Question 1

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) 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.
D) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

Accepted Answer

An externality can be either positive or negative, affecting other operations within the firm due to a new project or action. The example of a bank opening a new office and causing deposits in other offices to decline is a negative externality, illustrating how actions in one part of a business can impact other parts.

Question 2

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.

Accepted Answer

The correct choice is B because if the building could be sold, then choosing to use it for a new project instead of selling it means the project incurs an opportunity cost equal to the after-tax proceeds from the potential sale. This cost should be considered in the project's cash flow analysis.

Question 3

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

Previous expenditures such as costs associated with a market test that have already been expensed for tax purposes are considered sunk costs and should not be included in the projected cash flows of a new project. These costs have already occurred and cannot be recovered or changed by the decision to undertake or reject the project.

Question 4

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 for new projects can be positive or negative, depending on whether the project increases or decreases current assets more than current liabilities. It's not always true that new or replacement projects will require more working capital; it depends on the specifics of the project and how it affects the company's operations.

Question 5

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.

Accepted Answer

The expected sales reduction of an existing product is relevant in estimating the cash flows of the proposed project. The other options are not relevant in determining the cash flows of the project.

Question 6

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 text describes cannibalization as a situation where a new product or service offered by a firm decreases sales of the firm's existing product or service, potentially harming the firm's own profitability. Cannibalization is not illegal and is not dealt with by antitrust laws. Option A and B are incorrect. Option C is incorrect because increasing cash flows would offset the effects of cannibalization, but it would not necessarily eliminate them altogether. Option D is incorrect because cannibalization would decrease the overall NPV of the project. Therefore, option E is the correct choice.

Question 7

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.

Accepted Answer

The cash flows used to estimate a project's NPV should include the end-of-project recovery of any working capital required to operate the project. Options A and B are incorrect because costs incurred prior to the analysis and interest on funds borrowed should be considered sunk costs and not included in the cash flows. Option D is incorrect because cannibalization effects should be included regardless of whether they increase or decrease the project's projected cash flows.

Question 8

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 or changed by any current or future decisions. Therefore, they are not relevant to the analysis of a new capital budgeting project.

Question 9

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 if the firm decides not to go forward with the project. Option A is not correct because not all costs incurred to complete a project are sunk costs. Option B is incorrect because sunk costs cannot be recovered if the firm decides not to go forward with the project. Option D is partially correct but the approach of simply including sunk costs in cash flows and calculating the PV of the project is incorrect. Finally, option E is incorrect because a decline in sales of an existing store due to the opening of a new store is not a sunk cost.

Question 10

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 cash flows are not directly affected by the depreciation method since depreciation is a non-cash expense. Over the entire life of the project, total depreciation and thus the total impact on net income will be the same; only the timing differs.

Question 11

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.

Accepted Answer

Sunk costs are past costs that have already been incurred and cannot be recovered. The money spent last year to investigate a site for a new office, which was then expensed for tax purposes, is a sunk cost because it cannot be recovered regardless of whether the project goes forward.

Question 12

Which of the following statements is CORRECT?
A) Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
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 for both stockholder reporting and tax purposes.
D) Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.

Accepted Answer

Using accelerated depreciation leads to higher tax savings in the early years, thus speeding up cash flows and increasing the NPV of a project. However, it is important to note that this benefit comes at the cost of lower tax savings in later years.

Question 13

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

Using accelerated depreciation allows a firm to write off assets faster than they could under straight-line depreciation, which reduces taxable income and increases cash flows. Therefore, projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes. This makes option E the correct statement. Option A is incorrect because depreciation is used to calculate taxable income, which does affect cash flows. Option B is incorrect because corporations have the option to use other depreciation methods besides straight-line. Option C and D are incorrect because they contradict each other and are both misleading - using accelerated depreciation can either increase or decrease a project's NPV depending on the specifics of the project and tax laws.

Question 14

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 are lost from choosing one option over another. In the context of a business project evaluation, opportunity costs can include 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 15

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 the net impact on the company's overall revenue.

Question 16

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

Based on the WACC used by Tapley Inc., Project B, which has a below-average risk and an IRR of 8.5%, would be the best choice since its IRR is greater than the WACC used for below-average risk projects. We cannot determine if Projects A and C should be accepted without their NPV calculations. Therefore, options A, C, D, and E are incorrect.

Question 17

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.

Accepted Answer

Using accelerated depreciation instead of straight line depreciation affects the timing of cash flows, which in turn affects the NPV. The total projected cash flows would remain the same regardless of the depreciation method chosen. Option B is not correct as companies are allowed to use various methods of depreciation based on their preference. Option C is incorrect as companies can use different depreciation methods for reporting and tax purposes. Option D is incorrect as depreciation is a non-cash expense that affects the cash flow and the capital budgeting decisions.

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.

Accepted Answer

The CFO should include the investment in working capital required to operate the project in the cash flows. This is because the investment in working capital is a cost that will be incurred at the beginning of the project and will be recovered at the end of the project's life. However, it is still a cash outflow that needs to be considered when calculating the NPV. The other options are incorrect because sunk costs that have been incurred in the past should not be considered when making decisions about future cash flows, interest expenses on debt are a financing cost and should not be included in the calculation of the project's cash flows, and sunk costs incurred only in the current year are irrelevant for the purposes of estimating relevant cash flows for the project.

Question 19

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 and the steeper the graph of the relationship line, the more risky the project, other things held constant.

Question 20

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.

Accepted Answer

Adjusting the discount rate upward if the project is judged to have above-average risk is the best way to account for the relative risk of a proposed project. This is because a higher discount rate will reflect the higher risk associated with the project and result in a lower present value. This approach is consistent with the concept of risk-return tradeoff in finance where higher returns are expected for higher levels of risk.

Quiz 11: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

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

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

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

Which of the following statements is CORRECT?

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?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

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?

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