Question 1

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

While forecasting techniques have improved, estimating cash flows is still a complex and challenging task in the capital budgeting process. Factors such as uncertainty, market changes, and unexpected events can make it difficult to accurately predict future cash flows.

Question 2

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

Accepted Answer

While initial outlays and subsequent costs can be forecasted with accuracy, it is still difficult to accurately forecast the revenues a project will generate, even for large product development projects.

Question 3

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken,assuming the asset is used for its full tax life,is greater.

Accepted Answer

The total amount of depreciation that can be taken over an asset's life is the same under both methods; the difference lies in the timing of the depreciation expense, with accelerated depreciation allowing for higher deductions in the earlier years.

Question 4

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 obtaining a reasonably accurate estimate of projects' cash flows.

Accepted Answer

Estimating project cash flows is indeed the most important but also the most challenging aspect of the capital budgeting process. While selecting a methodology, such as NPV or IRR, is also crucial, accurately estimating cash flows and incorporating all possible factors is of primary importance.

Question 5

A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation,other things being equal.

Accepted Answer

Accelerated depreciation reduces taxable income in the early years of a project, leading to a higher present value of tax savings and a higher NPV. This can also result in higher cash flows in the early years of a project, resulting in a higher IRR. Therefore, a firm that uses NPV or IRR as its capital budgeting decision-making tool is more likely to accept a project that uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

Question 6

If debt is to be used to finance a project,then when cash flows for a project are estimated,interest payments should be included in the analysis.

Accepted Answer

Interest payments are not included in the cash flow analysis because cash flows are analyzed on a pre-financing basis to assess the project's operational viability, and financing costs are accounted for separately in the discount rate.

Question 7

Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets,not working capital.

Accepted Answer

Changes in net working capital should be reflected in a capital budgeting cash flow analysis because it is a cash flow and affects the project's overall financial performance. Working capital is necessary to operate fixed assets and should therefore be considered in evaluating a project's profitability.

Question 8

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

The coefficient of variation is a better measure of risk when comparing securities with significantly different expected returns because it standardizes the risk per unit of return, allowing for a more meaningful comparison across different scales of expected returns.

Question 9

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

Accepted Answer

This is true because externalities, such as changes in market conditions, technological advancements or government regulations, can impact the long-term cash flows of a business. Therefore, to accurately estimate cash flows, these externalities must be considered.

Question 10

Any cash flows that can be classified as incremental to a particular project⎯i.e.,results directly from the decision to undertake the project⎯should be reflected in the capital budgeting analysis.

Accepted Answer

This statement is true. Incremental cash flows are the cash flows that are directly related to a particular project and are relevant in capital budgeting analysis. Therefore, they should be included in the analysis.

Question 11

The coefficient of variation,calculated as the standard deviation of expected returns divided by the expected return,is a standardized measure of the risk per unit of expected return.

Accepted Answer

This is the correct definition of the coefficient of variation.

Question 12

Suppose a firm's CFO thinks that an externality is present in a project,but that it cannot be quantified with any precision⎯estimates of its effect would really just be guesses.In this case,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 really is.

Accepted Answer

If the externality is potentially important, it should not be ignored, because then a large error might be made. At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of the possible effects of the externality.

Question 13

If a firm's projects differ in risk,then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

Accepted Answer

This is true as projects with higher risk should have a higher discount rate to reflect the greater risk and uncertainty involved. This ensures that the firm is appropriately compensated for taking on riskier projects.

Question 14

Typically,a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation.This is because the total cash flows over the project's life will be higher if accelerated depreciation is used,other things held constant.

Accepted Answer

Accelerated depreciation affects the timing of tax deductions, leading to earlier tax savings and potentially a higher present value of those savings, but it does not change the total cash flows over the project's life, as the total depreciation expense remains the same.

Question 15

Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward,thus increasing their present value.On the other hand,using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses.However,the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.

Accepted Answer

Accelerated depreciation can bring tax savings and increase present value, but it may lower reported profits. To solve this, different depreciation methods can be used for tax and stockholder reporting.

Question 16

We can identify the cash costs and cash inflows to a company that will result from a project.These could be called "direct inflows and outflows," and the net difference is the direct net cash flow.If there are other costs and benefits that do not flow from or to the firm,but to other parties,these are called externalities,and they need not be considered as a part of the capital budgeting analysis.

Accepted Answer

Externalities should be considered in the capital budgeting analysis because they can indirectly affect the project's cash flows and the overall value to the firm. For example, a project might have positive externalities that could lead to increased market demand for the company's other products, or negative externalities that could harm the company's reputation and reduce future cash flows.

Question 17

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher,other things held constant.

Accepted Answer

Accelerated depreciation allows for larger tax deductions in the earlier years of an asset's life, resulting in greater tax savings and a higher present value of those savings over time. This is because the tax savings in earlier years can be invested and earn a return, increasing their present value.

Question 18

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

Accepted Answer

While superior analytical techniques and risk-adjusted cost of capital estimates can improve the quality of investment decision-making, they cannot fully overcome the problem of poor cash flow estimation. Accurate cash flow forecasts are fundamental to the reliability of any financial analysis, including NPV calculations.

Question 19

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

Accepted Answer

The opportunity cost of the land is the value of the next best alternative use for the land that is foregone when the land is used for the investment project. Even though the firm already owns the land, it could have used or sold the land for another purpose, and therefore the investment project should be charged with the opportunity cost of the land.

Question 20

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 included in a capital budgeting analysis.

Accepted Answer

Changes in noncash balance sheet accounts such as inventory do affect cash flows and therefore must be considered in a capital budgeting analysis. Failure to do so can result in inaccurate projections and decisions.

Quiz 13: Cash Flow Estimation and Risk Analysis