CHAPTER 11—CASH FLOW ESTIMATION AND RISK ANALYSIS
TRUE/FALSE
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.
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.
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.
4. 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.
5. 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.
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.
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.
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.
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.
10. 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.
11. 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.
12. 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.
13. 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.
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.
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.
16. 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.
17. 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.
18. 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.
19. 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.
20. 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.
21. 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.
22. 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.
23. 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.
24. 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.
25. 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.
26. 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.
27. Sensitivity analysis measures a project’s stand-alone risk by showing how much the project’s NPV (or
IRR) is affected by a small change in one of the input variables, say sales. Other things held constant,
with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical
axis, the steeper the graph of the relationship line, the more risky the project, other things held
constant.
28. Because of differences in the expected returns on different investments, the standard deviation is not
always an adequate measure of risk. However, the coefficient of variation adjusts for differences in
expected returns and thus allows investors to make better comparisons of investments’ stand-alone
risk.
MULTIPLE CHOICE
29. 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.
30. Which of the following procedures best accounts for the relative risk of a proposed project?
a.
Adjusting the discount rate downward 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.
e.
Adjusting the discount rate upward if the project is judged to have above-average risk.
31. Puckett Inc. risk-adjusts its WACC to account for project risk. It 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 Puckett accept, assuming that the company uses the NPV
method when choosing projects?
a.
Project B, which has below-average risk and an IRR = 8.5%.
b.
Project C, which has above-average risk and an IRR = 11%.
c.
Without information about the projects’ NPVs we cannot determine which project(s)
should be accepted.
d.
All of these projects should be accepted.
e.
Project A, which has average risk and an IRR = 9%.
32. 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.
33. 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.
34. 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.
35. 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.
36. 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.
37. 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 for both stockholder reporting and
tax purposes.
c.
Using accelerated depreciation rather than straight line normally has the effect of speeding
up cash flows and thus increasing a project’s forecasted NPV.
d.
Using accelerated depreciation rather than straight line normally has no effect on a
project’s total projected cash flows nor would it affect the timing of those cash flows or the
resulting NPV of the project.
e.
Since depreciation is a cash expense, the faster an asset is depreciated, the lower the
projected NPV from investing in the asset.
38. 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 3 years or longer.
b.
If firms use accelerated depreciation, they will write off assets slower than they would
under straight-line depreciation, and as a result projects’ forecasted NPVs are normally
lower than they would be if straight-line depreciation were required for tax purposes.
c.
If they use accelerated depreciation, firms can write off assets faster than they could under
straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower
than they would be if straight-line depreciation were required for tax purposes.
d.
If they use accelerated depreciation, firms can write off assets faster than they could under
straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher
than they would be if straight-line depreciation were required for tax purposes.
e.
Since depreciation is not a cash expense, and since cash flows and not accounting income
are the relevant input, depreciation plays no role in capital budgeting.
39. 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.
40. 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.
41. 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.
42. 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.
43. 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%.
44. 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.
45. 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.
46. 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.
47. 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.
48. 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.
49. 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.
50. To increase productive capacity, a company is considering a proposed new plant. Which of the
following statements is CORRECT?
a.
Since depreciation is a non-cash expense, the firm does not need to deal with depreciation
when calculating the operating cash flows.
b.
When estimating the project’s operating cash flows, it is important to include both
opportunity costs and sunk costs, but the firm should ignore the cash flow effects of
externalities since they are accounted for in the discounting process.
c.
Capital budgeting decisions should be based on before-tax cash flows.
d.
The WACC used to discount cash flows in a capital budgeting analysis should be
calculated on a before-tax basis.
e.
In calculating the project’s operating cash flows, the firm should not deduct financing costs
such as interest expense, because financing costs are accounted for by discounting at the
WACC. If interest were deducted when estimating cash flows, this would, in effect,
“double count” it.
51. Tallant Technologies is considering two potential projects, X and Y. In assessing the projects’ risks,
the company estimated the beta of each project versus both the company’s other assets and the stock
market, and it also conducted thorough scenario and simulation analyses. This research produced the
following data:
Project X
Project Y
Expected NPV
$500,000
$500,000
Standard deviation (NPV)
$200,000
$250,000
Project beta (vs. market)
1.4
0.8
Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are
not correlated with the cash flows from existing projects. Cash flows are highly correlated with the
cash flows from existing projects.
Which of the following statements is CORRECT?
a.
Project X has more corporate (or within-firm) risk than Project Y.
b.
Project X has more market risk than Project Y.
c.
Project X has the same level of corporate risk as Project Y.
d.
Project X has less market risk than Project Y.
e.
Project X has more stand-alone risk than Project Y.
52. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and
profits are positively correlated with the overall economy. The company estimates that the proposed
new project would have a higher standard deviation and coefficient of variation than an average
company project. Also, the new project’s sales would be countercyclical in the sense that they would
be high when the overall economy is down and low when the overall economy is strong. On the basis
of this information, which of the following statements is CORRECT?
a.
The proposed new project would increase the firm’s corporate risk.
b.
The proposed new project would increase the firm’s market risk.
c.
The proposed new project would not affect the firm’s risk at all.
d.
The proposed new project would have less stand-alone risk than the firm’s typical project.
e.
The proposed new project would have more stand-alone risk than the firm’s typical
project.
53. A firm is considering a new project whose risk is greater than the risk of the firm’s average project,
based on all methods for assessing risk. In evaluating this project, it would be reasonable for
management to do which of the following?
a.
Increase the estimated NPV of the project to reflect its greater risk.
b.
Reject the project, since its acceptance would increase the firm’s risk.
c.
Ignore the risk differential if the project would amount to only a small fraction of the
firm’s total assets.
d.
Increase the cost of capital used to evaluate the project to reflect its higher-than-average
risk.
e.
Increase the estimated IRR of the project to reflect its greater risk.
54. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite)
WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk,
and Laramie evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-
risk projects at 12%. The company is considering the following projects:
Project
Risk
Expected Return
A
High
15%
B
Average
12%
C
High
11%
D
Low
9%
E
Low
6%
Which set of projects would maximize shareholder wealth?
a.
A and B.
b.
A, B, and C.
c.
A, B, and D.
d.
A, B, C, and D.
e.
A, B, C, D, and E.
Project
Risk
A
High
15%
12%
B
12%
10%
C
11%
12%
D
Low
E
Low
55. Which of the following statements is CORRECT?
a.
One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes
into account the probability of specific effects occurring, whereas scenario analysis cannot
account for probabilities.
b.
Well-diversified stockholders do not need to consider market risk when determining
required rates of return.
c.
Market risk is important, but it does not have a direct effect on stock prices because it only
affects beta.
d.
Simulation analysis is a computerized version of scenario analysis where input variables
are selected randomly on the basis of their probability distributions.
e.
Sensitivity analysis is a good way to measure market risk because it explicitly takes into
account diversification effects.
56. Which of the following statements is CORRECT?
a.
In comparing two projects using sensitivity analysis, the one with the steeper lines would
be considered less risky, because a small error in estimating a variable such as unit sales
would produce only a small error in the project’s NPV.
b.
The primary advantage of simulation analysis over scenario analysis is that scenario
analysis requires a relatively powerful computer, coupled with an efficient financial
planning software package, whereas simulation analysis can be done efficiently using a PC
with a spreadsheet program or even with just a calculator.
c.
Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to
changes in key input variables and the probability of occurrence of these variables’ values.
d.
As computer technology advances, simulation analysis becomes increasingly obsolete and
thus less likely to be used as compared to sensitivity analysis.
e.
Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the
probability of occurrence of the key input variables.
57. Which of the following procedures does the text say is used most frequently by businesses when they
do capital budgeting analyses?
a.
Differential project risk cannot be accounted for by using “risk-adjusted discount rates”
because it is highly subjective and difficult to justify. It is better to not risk adjust at all.
b.
Other things held constant, if returns on a project are thought to be positively correlated
with the returns on other firms in the economy, then the project’s NPV will be found using
a lower discount rate than would be appropriate if the project’s returns were negatively
correlated.
c.
Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs
are then used to determine a trial NPV, and a number of trial NPVs are averaged to find
the project’s expected NPV. Sensitivity and scenario analyses, on the other hand, require
much more information regarding the input variables, including probability distributions
and correlations among those variables. This makes it easier to implement a simulation
analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently
used procedure.
d.
DCF techniques were originally developed to value passive investments (stocks and
bonds). However, capital budgeting projects are not passive investments⎯managers can
often take positive actions after the investment has been made that alter the cash flow
stream. Opportunities for such actions are called real options. Real options are valuable,
but this value is not captured by conventional NPV analysis. Therefore, a project’s real
options must be considered separately.
e.
The firm’s corporate, or overall, WACC is used to discount all project cash flows to find
the projects’ NPVs. Then, depending on how risky different projects are judged to be, the
calculated NPVs are scaled up or down to adjust for differential risk.