Question 1

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

Externalities, both positive and negative, can have an impact on a firm's long-term cash flows. For example, government regulations aimed at reducing pollution may increase a firm's costs, while positive effects of a new infrastructure project in the area may increase demand for the firm's products/services. Therefore, it is important to take externalities into account while estimating cash flows.

Question 2

The two cardinal rules that financial analysts should follow to avoid capital budgeting errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions.

Accepted Answer

The first rule is incorrect because in the NPV (Net Present Value) equation, the numerator should use cash flows, not income calculated in accordance with generally accepted accounting principles (GAAP). The second rule is correct, as all incremental cash flows should indeed be considered in making accept/reject decisions.

Question 3

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 using land that the firm already owns is the potential value of what the land could have been used for if it was not used for the investment project. Therefore, the investment project should be charged with the opportunity cost of the land.

Question 4

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 cost refers to the potential benefits or cash inflows that a firm could earn from alternative uses of its existing assets, which are not being used for the project under consideration. Therefore, option A is correct.

Question 5

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) Shipping and installation costs.
B) Cannibalization effects.
C) Opportunity costs.
D) Sunk costs that have been expensed for tax purposes.
E) Changes in net working capital.

Accepted Answer

Sunk costs that have already been expensed for tax purposes are not relevant cash flows as they are already accounted for in the company's financial statements. The other options are relevant cash flows, as they involve cash flows that are directly related to the project being analyzed. Shipping and installation costs, cannibalization effects, opportunity costs, and changes in net working capital are all relevant in determining the cash flows associated with a capital budgeting project.

Question 6

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. The accuracy of accept/reject decisions is fundamentally dependent on the quality of the cash flow projections.

Question 7

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) 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.
D) 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.
E) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

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. It is irrelevant to future decisions and should not be considered in the decision-making process. Option A is incorrect because sunk costs cannot be recovered. Option C is partially true but oversimplified. NPV method takes into account all the cash flows, including sunk costs, but it does not solve the problem of sunk costs. Option D is incorrect because the example given is not a sunk cost. Option E is incorrect because the cost that must be expended to complete a project is a necessary cost, not a sunk cost.

Question 8

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 customers. Thus, cannibalization is dealt with by society through the antitrust laws.
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 if cannibalization is considered will be higher than the NPV if this effect is not recognized.
D) 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.
E) 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.

Accepted Answer

Cannibalization refers to a situation where a company's new product eats into the sales of one of its existing products. This is not illegal or dealt with through antitrust laws; rather, it's a strategic and financial consideration for the company itself.

Question 9

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 is often used for such projects along with discounted cash flow analysis.

Accepted Answer

This statement is true. Large, complex projects often involve a lot of uncertainties, making it challenging to estimate the potential cash inflows and outflows accurately. As a result, subjective judgment is often employed to inform decision-making, and discounted cash flow analysis can help in evaluating the financial feasibility of such projects.

Question 10

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

This statement is true as estimating cash flows is crucial in determining the financial viability of a project, and even though methodology is important, the accuracy of cash flow estimation is more crucial.

Question 11

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 improvements in forecasting techniques have certainly made the process of estimating cash flows more accurate and reliable, it is still a complex and challenging task that involves making assumptions and projections about future economic and market conditions, as well as factors specific to the project itself. In addition, there are various sources of uncertainty and risk that can affect cash flows, such as changes in customer demand, competition, regulatory changes, and unexpected events. Therefore, while forecasting has become more sophisticated, it is still an important and difficult step in the capital budgeting process.

Question 12

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

Incremental cash flows are the cash flows that are directly related to a particular project and should be included in the capital budgeting analysis.

Question 13

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) 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.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 14

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 must be considered in capital budgeting analysis as they can have an impact on cash flows. For example, an increase in inventory may tie up cash and decrease cash flows, while a decrease in inventory may free up cash and increase cash flows.

Question 15

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

The presence of an externality, even if it cannot be precisely quantified, should still be considered in the analysis because it can have significant effects on the overall outcome of the project. Ignoring it completely would result in an incomplete evaluation of the project's potential costs and benefits.

Question 16

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. Financing effects are accounted for separately when calculating the net present value (NPV) or internal rate of return (IRR) by using the cost of capital, which reflects the cost of debt and equity.

Question 17

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 of a project can be forecasted with great accuracy, it is extremely difficult to make accurate forecasts of the revenues that a project will generate, especially for large product development projects.

Question 18

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 its financial impact.

Question 19

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 benefit other projects or the firm's reputation, leading to increased future cash flows.

Question 20

Which of the following statements is CORRECT?
A) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
B) 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.
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 that cost 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.
E) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

Accepted Answer

Sunk costs are past costs that have already been incurred and cannot be recovered. They should not influence the decision-making process for future investments. Choice C correctly identifies a sunk cost as the money spent and expensed for tax purposes on investigating a site for a potential new office, which is now a past expense irrelevant to the decision on whether to proceed with the project.

Quiz 11: Cash Flow Estimation and Risk Analysis

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.

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.

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.

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

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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 is often used for such projects along with discounted cash flow analysis.

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.

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

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.

Which of the following statements is CORRECT?

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.

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.

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.

Which of the following statements is CORRECT?