Question 1

Sometimes analysts think that an externality is present in a project,but they recognize that the particular externality cannot be quantified with any precision-estimates of its effect would really just be guesses.In such a situation,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 actually is.

Accepted Answer

While it might be challenging to quantify an externality with precision, it is still important to acknowledge its presence in the analysis. Ignoring it completely could lead to an incomplete assessment of the project's impacts. Analysts often use qualitative descriptions, sensitivity analysis, or scenario analysis to incorporate the effects of externalities when precise quantification is not possible.

Question 2

If an investment project would make use of land that the firm currently owns,the project should be charged with the opportunity cost of the land.

Accepted Answer

This is because the opportunity cost of the land is the value of the next best alternative foregone by using the land for the investment project. Therefore, the cost of using the land for the investment project should be calculated as the revenue that would have been generated by using the land for the next best alternative.

Question 3

If a firm's projects differ in risk,then different projects should be evaluated using risk-adjusted discount rates.

Accepted Answer

This is true because different projects may have different levels of risk, and using a risk-adjusted discount rate helps to account for this variability in risk. By adjusting the discount rate to reflect the level of risk associated with a particular project, a firm can more accurately estimate the future cash flows associated with that project and make more informed investment decisions.

Question 4

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected sales include sales that will be taken away from another of Walker's books.The lost sales on the existing book are a sunk cost and as such should not be considered in the analysis of the new book.

Accepted Answer

The lost sales on the existing book are considered an opportunity cost, not a sunk cost, and should be included in the analysis of the new book to accurately assess its financial impact.

Question 5

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 estimating projects' cash flows.

Accepted Answer

Estimating project cash flows is crucial as it determines the financial viability of the project. Methodology such as NPV and IRR are important, but they rely on the accuracy of estimated cash flows. Therefore, estimating cash flows is the most important and challenging step in the capital budgeting process.

Question 6

Using the same discount rate to evaluate projects with differing degrees of risk would,over time,cause the firm to accept too many high-risk projects and to reject too many low-risk proposals.

Accepted Answer

Using the same discount rate for all projects regardless of their risk level would lead to overemphasizing the benefits of high-risk projects, making them appear more attractive than they actually are, while simultaneously undervaluing the benefits of low-risk projects, making them seem less profitable than they would be. As a result, the firm may accept too many high-risk projects and reject too many low-risk proposals, which could hurt its overall financial performance. Therefore, it's important for the firm to adjust the discount rate to reflect the risk associated with each project or use other risk-adjusted evaluation methods to make more informed decisions.

Question 7

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

Even with improvements in forecasting techniques, estimating cash flows can still be a complex and uncertain process. Other steps in the capital budgeting process, such as determining the appropriate discount rate and evaluating alternative investment opportunities, can also be challenging.

Question 8

The undepreciated capital cost (UCC) is defined as the total cost of all assets in a class less the accumulated CCA for that class.

Accepted Answer

This is the correct definition of undepreciated capital cost (UCC).

Question 9

The primary advantage of declining-balance depreciation over straight-line depreciation is that,while the total amount of depreciation and thus tax savings is unchanged,charges are taken sooner.This means that the firm gets the benefits of the tax savings sooner,which increases their present value.

Accepted Answer

Declining-balance depreciation allows for larger depreciation charges in the earlier years of an asset's life, resulting in greater tax savings and benefits to the firm's present value over time. This is in contrast to straight-line depreciation, where depreciation charges are spread evenly over an asset's life, resulting in smaller tax savings in the earlier years. Therefore, the statement that declining-balance depreciation provides tax savings sooner and increases present value is true.

Question 10

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 relevant in a capital budgeting analysis.

Accepted Answer

Changes in noncash balance sheet accounts such as inventory can affect cash flows and must be considered in capital budgeting analysis. This is because changes in inventory levels can affect the cash outflows and inflows in a project, such as changes in working capital requirements or carrying costs.

Question 11

Superior analytical techniques,such as NPV,used in combination with cost of capital adjustments,can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions.

Accepted Answer

Superior analytical techniques and cost of capital adjustments can improve decision-making but cannot overcome the fundamental problem of poor cash flow estimation, as the accuracy of these decisions heavily depends on the quality of the cash flow projections.

Question 12

When the cash flows for a project are estimated,interest payments should be included if debt is to be used to help finance the project.

Accepted Answer

Interest payments are not included in the estimation of cash flows for a project because cash flow analysis focuses on the operational viability and profitability of the project itself, excluding financing costs to assess the project's ability to generate cash independently of its financing structure.

Question 13

In capital budgeting terminology,an externality is defined as something that is outside,or external to,a proposed new project.Therefore,externalities are not considered in project cash flow estimates.

Accepted Answer

Externalities are factors that are external to the proposed project but still have an impact on its cash flows. Examples of externalities include changes in the economy, government regulations, and fluctuations in the market. Since externalities can affect a project's cash flows, they should be considered in capital budgeting analysis.

Question 14

Opportunity costs include those cash inflows that could be generated from assets the firm already owns,if those assets were not used for the project being evaluated.

Accepted Answer

Opportunity cost refers to the benefits or cash inflows that are forgone when one alternative is chosen over another. In the context of capital budgeting, opportunity costs include the potential cash inflows that could be generated from assets the firm already owns if those assets were not used for the project being evaluated. Therefore, the statement is true.

Question 15

In cash flow estimation,the existence of externalities must be taken into account if those externalities have any effects on the firm's cash flows.

Accepted Answer

Externalities, such as changes in the economy or industry-specific factors, can impact a firm's cash flows. Thus, it is important to consider such factors when estimating cash flows.

Question 16

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 instead of a discounted cash flow analysis is recommended for such projects.

Accepted Answer

Discounted cash flow analysis is a fundamental financial tool used to estimate the value of a project by forecasting the cash flows it will generate in the future and discounting them back to their present value. Despite the challenges and uncertainties in estimating revenues and costs for large, complex projects, this method incorporates risk assessments and allows for a more objective and structured approach to evaluating long-term projects compared to relying solely on subjective judgment.

Question 17

Changes in net operating working capital do not need to be considered 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 do need to be considered in a capital budgeting cash flow analysis as they can have a significant impact on the cash flows of a project. Working capital is necessary to support the day-to-day operations of a business and changes in it can affect a project's cash inflows and outflows.

Question 18

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate,the project's initial outlays and subsequent costs for large projects can be forecasted with great accuracy.

Accepted Answer

While initial outlays and subsequent costs can be forecasted with some degree of accuracy, it is still subject to uncertainties and unforeseen circumstances. Therefore, it is not possible to forecast them with "great accuracy."

Question 19

The two cardinal rules that financial analysts follow to avoid capital budgeting errors are (1) capital budgeting decisions must be based on accounting income,and (2) all incremental cash flows should be considered when making accept/reject decisions.

Accepted Answer

The statement is false. The two cardinal rules that financial analysts follow to avoid capital budgeting errors are (1) capital budgeting decisions must be based on cash flows, not accounting income and (2) all relevant cash flows, both positive and negative, should be considered when making accept/reject decisions.

Question 20

Within the same asset class in the same year,when the sale of assets exceeds the purchase,net acquisition is negative.The half-year rule will apply.

Accepted Answer

The half-year rule, which typically applies to the calculation of depreciation for tax purposes, allowing only a half-year's worth of depreciation in the year of acquisition, is not directly related to whether net acquisition is positive or negative. Net acquisition being negative indicates that sales exceed purchases, but this does not determine the application of the half-year rule.

Quiz 11: Cash Flow Estimation and Risk Analysis