Question 1

The incremental cash flow principle claims that sunk costs must be taken into account in the firm's decision whether to accept or reject a project.

Accepted Answer

The incremental cash flow principle states that sunk costs should not be included in the decision-making process because they are irrelevant to future cash flows. Only costs that are expected to occur in the future should be considered when deciding whether to accept or reject a project.

Question 2

Sunk costs are also called opportunity or alternative costs.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered, regardless of what decision is made. Opportunity or alternative costs refer to the benefits or potential gains that are foregone or sacrificed by choosing a certain option instead of another.

Question 3

Taxes are important in capital investment evaluation because they affect the accounting profits generated by an investment.

Accepted Answer

The answer of Taxes are important in capital investment evaluation...

Question 4

Sunk costs are irrelevant to capital investment evaluation because such evaluation is oriented toward the future.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered. These costs are irrelevant to capital investment evaluation because the evaluation is focused on the future costs and benefits of the investment, not the past costs. The decision should be based on the incremental costs and benefits of the investment, not the sunk costs.

Question 5

Of the two processes involved in capital budgeting, cash flow estimation and the application of analytical techniques like NPV and IRR, the more difficult is the application of the analytical techniques.

Accepted Answer

While cash flow estimation requires careful consideration and forecasting of future cash flows, the application of analytical techniques like NPV and IRR involves mathematical calculations that can be easily learned and applied.

Question 6

The lost salvage value of an asset replaced prior to the end of its useful life is a sunk cost.

Accepted Answer

The lost salvage value is considered an opportunity cost because it represents the potential income or value lost by replacing the asset early, not a sunk cost which is a cost already incurred and cannot be recovered.

Question 7

Basic overheads are usually considered fixed and left out of project analysis.

Accepted Answer

Basic overheads, such as rent and utilities, are typically considered fixed costs and are not included in project analysis as they do not vary with changes in the level of project activity.

Question 8

Decreases in working capital have to be funded with cash outflows just like the acquisition of any other asset.

Accepted Answer

Decreases in working capital actually release cash and do not require funding. This is because working capital is the difference between a company's current assets and current liabilities; a decrease typically means that a company is either increasing its current liabilities (e.g., through more accounts payable) or decreasing its current assets (e.g., by selling inventory), both of which can free up cash.

Question 9

According to the incremental cash flow principle, a firm should include both variable costs and fixed costs in the project's cash flows.

Accepted Answer

The answer of According to the incremental cash flow principle,...

Question 10

The incremental cash flow principle states that the new project's cash flows should include all increases or decreases in cash flows to the firm due to accepting the new project.

Accepted Answer

The incremental cash flow principle states that all incremental cash flows associated with accepting the new project should be considered in the analysis. This includes any increases or decreases in cash flows to the firm that are directly related to the project.

Question 11

It's important to keep the distinction between earnings and cash flows in mind when doing project projections. Managers invariably want to know the net income impact of projects as well as the results of the capital budgeting analysis.

Accepted Answer

It is important to keep the distinction between earnings (net income) and cash flows in mind when doing project projections, and managers often want to know both the net income impact and the results of the capital budgeting analysis.

Question 12

Including financing costs in the cash flow estimates would have the effect of counting them twice, once as a cash flow component, and once in the estimated discount rate.

Accepted Answer

Financing costs, such as interest payments, are already accounted for in the estimated discount rate. Including them as a separate cash flow component would result in counting them twice, overestimating their impact on the overall cash flow.

Question 13

A firm should evaluate a project according to the incremental cash flow principle and should incorporate only negative effects on other existing projects.

Accepted Answer

A firm should evaluate a project according to the incremental cash flow principle, incorporating both positive and negative effects on other existing projects. This means considering any additional revenues or cost savings as well as any potential losses or costs the new project may cause to existing operations.

Question 14

Sunk costs are monies that have already been spent at the time of the capital project analysis and cannot influence the future regardless of the decisions about the project.

Accepted Answer

Sunk costs are past costs that cannot be recovered and are irrelevant to future decision making.

Question 15

Sunk costs, but not taxes, are irrelevant to the evaluation of a capital budgeting project.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered, therefore they should not be considered in the decision to undertake a capital budgeting project. Taxes, on the other hand, are an important consideration as they affect the future cash flows of the project.

Question 16

The difference between total cash flows and incremental cash flows is due solely to the effect of income taxes.

Accepted Answer

The difference between total cash flows and incremental cash flows is not solely due to income taxes. Total cash flows include all cash inflows and outflows related to a project, while incremental cash flows only consider the additional cash flows generated by the project compared to the status quo or alternative investment options. Other factors besides income taxes, such as sunk costs, opportunity costs, and externalities, can also create a difference between total and incremental cash flows.

Question 17

The relevance of a sunk cost to the evaluation of a capital budgeting project depends on how recently in the past the cost was incurred.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered, and therefore should not influence the decision-making process for future investments or projects, regardless of how recently they were incurred.

Question 18

Capital budgeting consists of two distinct processes. The first is estimation of the cash flows associated with the specific projects being considered, and the second is use of techniques such as NPV and IRR to evaluate those estimates.

Accepted Answer

This statement is true. Capital budgeting involves estimating the cash flows of potential projects and then evaluating them using various techniques like NPV and IRR.

Question 19

Only incremental, after-tax cash flows are relevant to the evaluation of a capital budgeting project.

Accepted Answer

Only the incremental after-tax cash flows that will result if the project is implemented should be considered when evaluating a capital budgeting project. Non-incremental cash flows or sunk costs should not be included in the analysis. Additionally, any financing costs or tax effects should be taken into account to accurately measure the project's profitability.

Question 20

Since it has no tax effect, the increase in a firm's net working capital that is required by a capital investment should be ignored in the valuation of the investment.

Accepted Answer

The increase in net working capital is a cash outflow that needs to be considered when valuing a capital investment. Ignoring it would lead to an inaccurate valuation and potentially incorrect investment decision.

Quiz 11: Cash Flow Estimation