Question 1

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

Accepted Answer

Sensitivity analysis does measure the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales. And, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the more risky the project.

Question 2

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

Accepted Answer

The answer of Suppose Tapley Corporation uses a WACC of...

Question 3

Laurier Inc.,a household products firm,is considering production of a new detergent.In evaluating whether to go ahead with the project,which item should NOT be explicitly considered when cash flows are estimated?
A)The company will produce the detergent in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce other Laurier products.
B)The project will utilize some equipment the company currently owns but is not now using. A used-equipment dealer has offered to buy the equipment.
C)The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research is expected to benefit other projects that might be proposed in the future.
D)The new detergent will cut into sales of the firm's other detergents.

Accepted Answer

The $3 million already spent and expensed for tax purposes on research is a sunk cost and should not be considered in the cash flow estimation for the new project.

Question 4

What is the best approach to take into account the relative risk of a proposed project?
A)adjusting the discount rate upward if the project is judged to have above-average risk
B)reducing the NPV by 10% for risky projects
C)picking a risk factor equal to the average discount rate
D)ignoring risk because project risk cannot be measured accurately

Accepted Answer

The best approach is to adjust the discount rate upward if the project is judged to have above-average risk. This is because the discount rate reflects the time value of money and the risk associated with the project. When a project is riskier than average, its cash flows are considered less certain, hence, to account for this uncertainty, the discount rate should be adjusted upwards. This will reduce the NPV of the project, reflecting the higher risk. Choice B is not recommended as it does not take into account the specific level of risk associated with the project. Choice C is not appropriate because the average discount rate may not be reflective of the level of risk associated with the proposed project. Choice D is not recommended because risk is an important consideration in investment decision making, and cannot be ignored.

Question 5

When evaluating a new project,which statement should firms NOT include in the projected cash flows?
A)previous expenditures associated with a market test to determine the feasibility of the project provided those costs have been expensed for tax purposes
B)the value of a building owned by the firm that will be used for this project
C)a decline in the sales of an existing product provided that decline is directly attributable to this project
D)the salvage value of assets used for the project at the end of the project's life

Accepted Answer

Previous expenditures, such as costs for a market test that have already been expensed for tax purposes, are 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 the project.

Question 6

Which item 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 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

Cannibalization effects, such as the reduction in sales of existing products due to the introduction of a new product, should be considered in the cash flow analysis of a proposed project.

Question 7

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 answer 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 8

When determining the present value of the tax shield for assets being replaced rather than bought new,the calculation must reflect the cash flow difference (incremental cash flow) generated by the new and old assets.

Accepted Answer

It is true that when determining the present value of the tax shield for assets being replaced rather than bought new, the calculation must reflect the incremental cash flow generated by the new and old assets. This is because the tax shield is based on the depreciation of the assets, which is affected by the difference in their cash flows.

Question 9

Which of the following statements best describes a sunk cost?
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)A sunk cost is any cost not directly related to the physical work required to complete the project.

Accepted Answer

A sunk cost is defined as a cost that has already been incurred and cannot be recovered. Therefore, option 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," is the best description of a sunk cost. Option A is incorrect because it defines a cost that must be expended in order to complete a project, which is not necessarily a sunk cost. Option B is incorrect because it describes a cost that can be recovered, which is not applicable to sunk costs. Option D is incorrect because it describes a cost that is not directly related to the physical work required to complete the project, which is not necessarily a characteristic of sunk costs.

Question 10

After a project has been terminated,a firm cannot receive CCA deductions from it,and thus the CCA tax shield stops too.

Accepted Answer

The answer of After a project has been terminated,a firm...

Question 11

Which factor should be included in the cash flows used to estimate a project's NPV?
A)all overhead costs incurred
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 end-of-project recovery of any working capital is a relevant cash flow for NPV calculations as it represents cash inflows that will occur at the end of the project.

Question 12

Which of the following statements best describes externalities?
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 favourable 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 favour 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

Externalities refer to the positive or negative impact that a project or decision may have on parties not directly involved in that project or decision. The example of a new bank office causing deposits in other offices to decline illustrates a negative externality as it negatively affects parties not directly involved in the decision to open the new office. Option B correctly describes this concept. Options A, C, and D do not accurately describe externalities.

Question 13

Which of the following statements regarding CCA is true?
A)Since CCA is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
B)When corporations use CCA, the stockholder report financially looks better.
C)CCA is a pool concept calculating values for the entire asset class, not individual assets.
D)Using CCA declining-balance depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project's forecasted NPV.

Accepted Answer

CCA stands for Capital Cost Allowance and is a method of calculating tax depreciation in Canada. It is a pool concept, which means that assets in the same class are grouped together and depreciated collectively rather than individually. Choice A is incorrect because the rate of CCA depreciation does not impact cash flows or NPV directly. Choice B is incorrect because CCA only affects tax reporting, not financial reporting. Choice D is incorrect because declining-balance CCA depreciation is an accelerated method that results in faster depreciation and higher CCA deductions, which can improve a project's forecasted NPV.

Question 14

Which of the following statements regarding CCA is true?
A)Since CCA is not a cash expense, it plays no role in capital budgeting.
B)CCA uses a specific mandated CCA rate for each asset class.
C)The CCA deduction is equal to the year-end UCC for the pool divided by the mandated CCA rate.
D)CCA allows that the net capital cost of an asset is added to the pool in the year the asset is put in use.

Accepted Answer

CCA (Capital Cost Allowance) uses specific mandated rates for different asset classes as determined by tax regulations.

Question 15

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 (the initial investment cost,the annual operating cash flows,and the terminal cash flow),then discounting those cash flows at the company's WACC.Which factor should the CFO include in the cash flows when estimating the relevant cash flows?
A)all interest expenses on debt used to help finance the project
B)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
C)sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year
D)effects of the project on other divisions of the firm, but only if those effects lower the direct cash flows of the project

Accepted Answer

The CFO should include 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. This is because the investment in working capital is a cash outflow that is needed to operate the project and should be taken into account when estimating the relevant cash flows. Options A, C, and D are incorrect. Interest expenses on debt used to finance the project should be included in the calculation of the WACC, but not in the estimation of cash flows. Sunk costs that have been incurred relating to the project should not be included in the estimation of cash flows, as they are irrelevant to future cash flows. Effects of the project on other divisions of the firm, even those that lower the direct cash flows of the project, should not be included in the estimation of cash flows for the project, as they are not relevant to the project itself.

Question 16

Which of the following is NOT a cash flow and thus should not be reflected in the analysis of a capital budgeting project?
A)changes in net operating working capital
B)shipping and installation costs
C)cannibalization effects
D)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. They should not be considered in the analysis of a capital budgeting project because they do not represent future cash flows associated with the project.

Question 17

Which of the following statements is correct?
A)If a project can create employment in a slump area, the firm should include such an externality in the NPV calculations.
B)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.
C)If cannibalization is determined to exist, then this means that the calculated NPV considering cannibalization will be higher than the NPV that does not recognize these effects.
D)Cannibalization is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Accepted Answer

Cannibalization refers to a situation where a new project or product eats into the sales of the firm's existing products. It is not illegal, and the harm is internal to the firm, affecting its own product lines.

Question 18

Which of the following statements best describes CCA?
A)Using CCA rather than straight-line depreciation 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)Corporations must use the same depreciation method (e.g., straight-line or CCA) for stockholder reporting and tax purposes.
C)Since CCA is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
D)Under CCA rules, higher CCA deductions occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Accepted Answer

CCA (capital cost allowance) is a tax depreciation method that allows for accelerated deductions in the early years and slower deductions in later years. This affects the timing of the tax shield and can impact a project's NPV (net present value) calculation. However, it does not affect the total projected cash flows of a project. Therefore, statement A is the most accurate description of CCA. Statements B and C are incorrect, as corporations can choose different depreciation methods for stockholder reporting and tax purposes, and CCA does have an effect on cash flows. Statement D is partially correct, as higher CCA deductions do occur in the early years, but the reduced cash flows may not necessarily lower a project's NPV, as it depends on the specific project's cash flow pattern and discount rate.

Question 19

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

Accepted Answer

The change in net operating working capital associated with new projects can be either positive or negative. While it's common for new projects to require additional working capital, the actual change depends on the specifics of the project, such as the nature of the project, the industry, and the company's management of current assets and liabilities.

Question 20

Which of the following statements best describes a situation involving sunk costs?
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 money that a banking corporation spent last year to investigate the site for a new office, then expensed those funds for tax purposes, and now is deciding whether to go forward with the project.
D)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 refer to money that has already been spent and cannot be recovered. In choice C, the money spent by the banking corporation on investigating a site for a new office, which was then expensed for tax purposes, represents a sunk cost because it cannot be recovered regardless of whether the project goes forward.

Quiz 11: Cash Flow Estimation and Risk Analysis

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

Laurier Inc.,a household products firm,is considering production of a new detergent.In evaluating whether to go ahead with the project,which item should NOT be explicitly considered when cash flows are estimated?

What is the best approach to take into account the relative risk of a proposed project?

When evaluating a new project,which statement should firms NOT include in the projected cash flows?

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

When determining the present value of the tax shield for assets being replaced rather than bought new,the calculation must reflect the cash flow difference (incremental cash flow) generated by the new and old assets.

Which of the following statements best describes a sunk cost?

After a project has been terminated,a firm cannot receive CCA deductions from it,and thus the CCA tax shield stops too.

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

Which of the following statements best describes externalities?

Which of the following statements regarding CCA is true?

Which of the following statements regarding CCA is true?

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

Which of the following statements is correct?

Which of the following statements best describes CCA?

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

Which of the following statements best describes a situation involving sunk costs?