Question 1

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
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 that will be recovered at the end of the project's life.
E) Changes in net working capital attributable to the project.

Accepted Answer

Previous expenditures, such as costs associated with a market test that have already been expensed for tax purposes, are considered sunk costs and should not be included in the projected cash flows of a new project.

Question 2

Which of the following rules is CORRECT for capital budgeting analysis?
A) Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
B) Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision.
C) A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted.
D) If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis.
E) The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

Accepted Answer

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. This means that any cash flows that would occur regardless of whether or not the project is accepted are not considered in the analysis. Only the additional or incremental cash flows that result from the project are relevant.

Question 3

The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
A) All sunk costs that have been incurred relating to the project.
B) All interest expenses on debt used to help finance the project.
C) 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.
D) Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
E) Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

Accepted Answer

The investment in working capital required to operate the project must be included in the relevant cash flows when estimating NPV, even if that investment will be recovered at the end of the project's life. This is because it represents a cash outflow at the beginning of the project and a subsequent cash inflow at the end of the project, and thus affects the project's overall profitability. Sunk costs, whether incurred in the current year or prior years, should not be included, as they are irrelevant to the project's future cash flows. Interest expenses on debt used to finance the project should also not be included in the cash flows used for NPV calculation, as they are already reflected in the discount rate (WACC). Effects on other divisions of the firm should also not be considered, as the focus should only be on the project's own cash flows.

Question 4

Which of the following statements is CORRECT?
A) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
B) Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
C) Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
D) Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.
E) Using accelerated depreciation rather than straight line 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.

Accepted Answer

Option A is incorrect as the choice of method of depreciation is at the discretion of the corporation. Option B is incorrect as corporations can use different methods of depreciation for stockholder reporting and tax purposes. Option C is incorrect as depreciation impacts the profitability of the project and affects the taxes paid. Option D is incorrect as higher depreciation charges will lower taxes paid, thus increasing cash flows, and may increase the NPV. Option E is correct as accelerated depreciation affects the timing of the cash flows and thus the NPV.

Question 5

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
A) 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.
B) The company has spent and expensed $1 million on R&D associated with the new project.
C) The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the 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.
E) The new project is expected to reduce sales of one of the company's existing products by 5%.

Accepted Answer

The answer of Which of the following should be considered...

Question 6

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 expenses in the earlier years.

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 working capital is an important component of the overall cash flow of the project. It represents the difference between the current assets and current liabilities and reflects the amount of cash that is tied up in daily operations. As such, changes in working capital should be taken into account when estimating the cash flows associated with a capital investment project.

Question 8

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 a higher depreciation expense in the earlier years of an asset's life, leading to higher tax deductions and therefore greater tax savings in the present. This results in a higher present value of the tax savings compared to straight-line depreciation.

Question 9

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
A) A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
B) A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
C) A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
D) A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.
E) A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

Accepted Answer

The sunk costs associated with R&D that have already been expensed cannot be recovered and therefore do not result in incremental cash flows. The other options all involve tangible cash flows that would be impacted by the new product. A involves potential cannibalization of existing products, but still results in new sales. B involves tangible costs associated with obtaining new equipment. D involves potential increased sales of existing products. E involves the potential use or sale of valuable land.

Question 10

Which of the following statements is CORRECT?
A) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.
B) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
C) If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.
D) If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
E) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.

Accepted Answer

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

Question 11

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

The answer of Typically, a project will have a higher...

Question 12

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
A) Revenues from an existing product would be lost as a result of customers switching to the new product.
B) Shipping and installation costs associated with a machine that would be used to produce the new product.
C) The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
D) It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.
E) Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

Accepted Answer

The cost of a study relating to the market for the new product that was completed last year is a sunk cost as it has already been incurred and expensed for tax purposes last year, and it cannot be recovered. It would not result in incremental cash flows and should not be included in the capital budgeting analysis for a new product.

Question 13

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Accepted Answer

Accelerated depreciation causes net income to be lower in the early years of a project's life due to higher depreciation expenses, but it does not affect the total cash flows from operations, as depreciation is a non-cash expense. Over the life of the project, the total depreciation expense is the same for both methods, just allocated differently over time.

Question 14

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

Accepted Answer

The change in net working capital associated with new projects can be either positive or negative depending on various factors such as the timing of cash inflows and outflows, inventory management, and receivables and payables turnover. For example, a new project may require more initial working capital investment but can generate positive cash flows that offset the increase in net working capital. Similarly, a replacement project may require less net working capital if it involves more efficient technology or streamlined operations.

Question 15

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 allows a firm to claim larger depreciation expense in the earlier years of a project, which in turn reduces the firm's taxable income and increases its cash flow. This can enhance the net present value (NPV) and internal rate of return (IRR) of a project, making it more attractive to the firm. In contrast, straight-line depreciation results in a constant depreciation expense throughout the life of a project, which may not provide the same cash flow benefit. Therefore, a firm that uses NPV or IRR as the basis for its capital budgeting decisions may be more likely to accept a project that uses accelerated depreciation compared to straight-line depreciation, assuming all other factors are equal.

Question 16

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 increase.
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

An externality refers to a situation where the actions of a firm or project have an impact on parties not directly involved in the transaction. The example given in choice A, where a bank's new office increases deposits in its other offices, is an example of a positive externality affecting the bank's other operations.

Question 17

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

This statement is true as accelerated depreciation can increase the present value of cash flows but also lower reported profits. However, different depreciation methods can be used for tax and stockholder reporting to solve this issue.

Question 18

While developing a new product line, Cook 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. Cook owns the building free and clear⎯there is no mortgage on it. Which of the following statements is CORRECT?
A) 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.
B) 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.
C) 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.
D) If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
E) 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.

Accepted Answer

The answer of While developing a new product line, Cook...

Question 19

Which of the following factors should be included in the cash flows used to estimate a project's NPV?
A) Interest on funds borrowed to help finance the project.
B) The end-of-project recovery of any working capital required to operate the project.
C) Cannibalization effects, but only if those effects increase the project's projected cash flows.
D) Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
E) All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

Accepted Answer

The end-of-project recovery of any working capital required to operate the project should be included in the cash flows used to estimate a project's NPV. This is because working capital is typically invested to cover upfront costs and ongoing expenses, and at the end of a project, any remaining working capital should be returned to the company. Interest on funds borrowed, cannibalization effects, expenditures on research and development, and costs incurred prior to the analysis being conducted are all factors that may or may not be relevant to a project's cash flows, depending on the specific circumstances.

Question 20

Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
A) 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.
B) 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 may benefit other projects that might be proposed in the future.
C) The new product will cut into sales of some of the firm's other products.
D) If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project's life.
E) The company will produce the new product 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 another of the firm's products.

Accepted Answer

Sunk costs, such as the $3 million already spent and expensed for tax purposes on research, should not be considered in the evaluation of future projects because these costs cannot be recovered and do not affect the future cash flows of the new project.

Quiz 11: Cash Flow Estimation and Risk Analysis

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

Which of the following rules is CORRECT for capital budgeting analysis?

Which of the following statements is CORRECT?

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

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.

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.

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.

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

Which of the following statements is CORRECT?

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.

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

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

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.

Which of the following statements is CORRECT?

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

Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?