Chapter 12: Cash Flow Estimation and Risk Analysis
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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.
a. True
b. False
2. 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.
a. True
b. False
3. 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.
a. True
b. False
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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.
a. True
b. False
7. 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.
a. True
b. False
8. 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.
a. True
b. False
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11. Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because
capital budgeting relates to fixed assets, not working capital.
a. True
b. False
12. The primary advantage to immediately expensing depreciation rather than using straight-line depreciation is that with
immediate expensing the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is
greater.
a. True
b. False
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13. The primary advantage to immediately expensing depreciation rather than using straight-line depreciation is that with
immediate expensing the present value of the tax savings provided by depreciation will be higher, other things held
constant.
a. True
b. False
14. Typically, a project will have a higher NPV if the firm immediately expenses depreciation rather than using straight-
line depreciation. This is because the total cash flows over the project’s life will be higher if depreciation is immediately
expensed, other things held constant.
a. True
b. False
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 immediately expenses depreciation than if it uses straight-line depreciation, other things being equal.
a. True
b. False
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a. True
b. False
21. 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.
a. True
b. False
22. 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.
a. True
b. False
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25. 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. Changes in net operating working capital.
b. Shipping and installation costs for machinery acquired.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.
26. The relative risk of a proposed project is best accounted for by which of the following procedures?
a. Adjusting the discount rate upward if the project is judged to have above-average risk.
b. Adjusting the discount rate upward if the project is judged to have below-average risk.
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.
27. Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for
above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the
company uses the NPV method when choosing projects?
a. Project A, which has average risk and an IRR = 9%.
Chapter 12: Cash Flow Estimation and Risk Analysis
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b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
e. All of these projects should be accepted as they will produce a positive NPV.
28. Which of the following statements is CORRECT?
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. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to
simply include sunk costs in the cash flows and then calculate the project’s NPV.
e. 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.
29. Which of the following statements is CORRECT?
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.
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c. 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.
d. 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.
e. 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 have been had the sunk costs been ignored.
30. Which of the following statements is CORRECT?
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 favorable 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 favor 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.
e. Identifying an externality can never lead to an increase in the calculated NPV.
31. Which of the following statements is CORRECT?
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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 favorable 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 increase.
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 favor 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.
e. Identifying an externality can never lead to an increase in the calculated NPV.
32. 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
competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
b. 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.
c. 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.
d. 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.
e. 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.
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d. The new product will cut into sales of some of the firm’s other products.
e. If the project is accepted, the company must invest an additional $2 million in net operating working capital
(NOWC). However, all these funds will be recovered at the end of the project’s life.
43. Which of the following rules is CORRECT for capital budgeting analysis?
a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when
making accept/reject decisions for capital budgeting projects.
c. 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.
d. 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.
e. 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.
44. Which of the following statements is CORRECT?