Question 1

The relative risk of a proposed project is best accounted for by which of the following procedures?
A) Adjusting the discount rate upward if the project is judged to have above-average risk.
B) Adjusting the discount rate downward if the project is judged to have above-average risk.
C) Reducing the NPV by 10% for risky projects.
D) Picking a risk factor equal to the average discount rate.
E) Ignoring risk because project risk cannot be measured accurately.

Accepted Answer

Adjusting the discount rate upward for projects with above-average risk accounts for the increased uncertainty and potential variability in returns, thus providing a more conservative estimate of the project's value.

Question 2

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 3

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) Changes in net working capital. B) Shipping and installation costs. C) Cannibalization effects. D) Opportunity costs. E) Sunk costs that have been expensed for tax purposes.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered, and thus should not be considered in capital budgeting decisions.

Question 4

Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.

Accepted Answer

Sensitivity analysis does measure a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, and a steeper graph of the relationship line indicates a riskier project.

Question 5

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?
A) Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.
B) If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
C) This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
D) Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
E) If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

Accepted Answer

The answer of Rowell Company spent $3 million two years...

Question 6

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? A) Project A, which has average risk and an IRR = 9%. B) Project B, which has below-average risk and an IRR = 8.5%. C) Project C, which has above-average risk and an IRR = 11%. D) Without information about the projects' NPVs we cannot determine which project(s) should be accepted. E) All of these projects should be accepted.

Accepted Answer

Project B has a below-average risk with an IRR of 8.5%, which is higher than the WACC for below-average risk projects (8%), indicating a positive NPV.

Question 7

Which of the following statements is CORRECT? A) Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. B) Under current laws and regulations, corporations must use straight- line depreciation for all assets whose lives are 3 years or longer. C) If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. D) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. E) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Accepted Answer

Accelerated depreciation allows firms to write off assets faster, leading to higher initial tax savings and cash flows, which can increase the project's NPV compared to using straight-line depreciation.

Question 8

Which of the following factors should be included in the cash flows used to estimate a project's NPV? A) All costs associated with the project that have been incurred prior to the time the analysis is being conducted. B) Interest on funds borrowed to help finance the project. C) The end-of-project recovery of any working capital required to operate the project. D) Cannibalization effects, but only if those effects increase the project’s projected cash flows. E) Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

Accepted Answer

The end-of-project recovery of any working capital required to operate the project should be included in the cash flows for NPV estimation, as it represents a cash inflow at the project's end.

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

This is a correct statement. Opportunity costs represent the benefits or cash flows that are forgone or sacrificed by choosing one option over another, including the potential benefits or cash flows that could have been earned from alternative uses of the same resources. In the context of evaluating a new investment project, opportunity costs can include the cash inflows that could be generated from existing assets if they are not used for the new project.

Question 10

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: A) Changes in net working capital attributable to the project. B) Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. C) The value of a building owned by the firm that will be used for this project. D) A decline in the sales of an existing product, provided that decline is directly attributable to this project. E) The salvage value of assets used for the project that will be recovered at the end of the project's life.

Accepted Answer

The answer of When evaluating a new project, firms should...

Question 11

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Accepted Answer

Accelerated depreciation causes net income to be lower in the early years of a project's life due to higher depreciation expenses, but it does not affect the total cash flows from operations, as depreciation is a non-cash expense. Over the life of the project, the total depreciation expense is the same for both methods, just allocated differently over time.

Question 12

Which of the following statements is CORRECT?
A) Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase.
B) Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets.
C) If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth.
D) Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them.

Accepted Answer

Additional funds needed (AFN) are typically raised through financing decisions involving notes payable, long-term debt, and common stock, which are non-spontaneous sources of funds.

Question 13

The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.

Accepted Answer

The change in net working capital associated with new projects can be positive or negative depending on the working capital needs of the project. While it is true that some new projects may require more working capital, others may require less. Additionally, replacement projects may also result in a positive or negative change in net working capital depending on the differences in working capital needs between the existing and replacement assets.

Question 14

Which of the following statements is CORRECT?
A) Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
B) Under current laws and regulations, corporations must use straight- line depreciation for all assets whose lives are 5 years or longer.
C) Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
D) Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
E) Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Accepted Answer

The answer of Which of the following statements is CORRECT?
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Question 15

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? A) The new project is expected to reduce sales of one of the company’s existing products by 5%. B) Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost. C) The company has spent and expensed $1 million on R&D associated with the new project. D) The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. E) The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

Accepted Answer

The answer of Which of the following should be considered...

Question 16

Which of the following statements is CORRECT?
A) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
B) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
C) 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.
D) 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.
E) 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.

Accepted Answer

Sunk costs are past costs that have already been incurred and cannot be recovered. The money spent last year to investigate the site is a sunk cost and should not affect the decision to go forward with the project.

Question 17

Which of the following statements is CORRECT?
A) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
B) 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.
C) 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.
D) 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.
E) 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.

Accepted Answer

A sunk cost is a cost that has already been incurred and cannot be recovered, regardless of future actions.

Question 18

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? A) All sunk costs that have been incurred relating to the project. B) All interest expenses on debt used to help finance the project. C) The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life. D) Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. E) Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

Accepted Answer

The investment in working capital is a relevant cash flow because it represents a cash outflow at the start of the project and a cash inflow when it is recovered at the end.

Question 19

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 competitors. Thus, cannibalization is dealt with by society through the antitrust laws. B) 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. C) 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. D) 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. E) 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.

Accepted Answer

The statement that correctly describes cannibalization is that it is a type of externality that is not against the law, and any harm it causes is done to the firm itself. Cannibalization refers to a situation where a new product or service offered by a firm takes away sales from its existing products or services. It may have a negative impact on the sales and profits of the firm's existing products, but it is not considered illegal. Therefore, choice (E) is the correct answer. The other options are incorrect as they either describe the wrong consequences of cannibalization or propose incorrect ways of dealing with it.

Question 20

Taussig Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects. Which of the following statements is CORRECT? A) Project X has more stand-alone risk than Project Y. B) Project X has more corporate (or within-firm) risk than Project Y. C) Project X has more market risk than Project Y. D) Project X has the same level of corporate risk as Project Y. E) Project X has less market risk than Project Y.

Accepted Answer

The answer of Taussig Technologies is considering two potential projects,...

Quiz 11: Cash Flow Estimation and Risk Analysis

The relative risk of a proposed project is best accounted for by which of the following procedures?

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

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

Which of the following statements is CORRECT?

Which of the following factors should be included in the cash flows used to estimate a project's NPV?

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.

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Which of the following statements is CORRECT?

The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.

Which of the following statements is CORRECT?

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?