Chapter 12: Cash Flow and Risk True/False Page 439
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Note that there is some overlap between the T/F and the multiple choice questions, as some T/F
statements are used in the MC questions. See the preface for information on the AACSB letter
indicators (F, M, etc.) on the subject lines.
Multiple Choice: 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.
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
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.
a. True
b. False
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.
a. True
b. False
CHAPTER 12
CASH FLOW ESTIMATION AND RISK ANALYSIS
Page 440 True/False Chapter 12: Cash Flow and Risk
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
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.
a. True
b. False
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.
a. True
b. False
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
Chapter 12: Cash Flow and Risk True/False Page 441
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.
a. True
b. False
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.
a. True
b. False
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.
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 uses accelerated
depreciation than if it uses straight-line depreciation, other things
being equal.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
Page 442 True/False Chapter 12: Cash Flow and Risk
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 for capital budgeting projects.
a. True
b. False
19. 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.
a. True
b. False
20. The two cardinal rules that financial analysts should follow to avoid
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 for capital budgeting projects.
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
23. The change in net operating working capital associated with new
projects is always positive, because new projects mean that more
operating working capital will be required.
a. True
b. False
Chapter 12: Cash Flow and Risk Conceptual M/C Page 443
24. 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.
a. True
b. False
25. 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.
a. True
b. False
Multiple Choice: Conceptual
26. 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.
27. 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.
28. 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%.
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.
Page 444 Conceptual M/C Chapter 12: Cash Flow and Risk
e. All of these projects should be accepted as they will produce a
positive NPV.
29. 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.
30. 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.
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.
31. 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.
Chapter 12: Cash Flow and Risk Conceptual M/C Page 445
32. 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 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.
33. 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.
34. Which of the following statements is CORRECT?
a. 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.
b. Under current laws and regulations, corporations must use straight–
line depreciation for all assets whose lives are 5 years or longer.
c. Corporations must use the same depreciation method (e.g., straight
line or accelerated) for stockholder reporting and tax purposes.
d. Since depreciation is not a cash expense, it has no effect on cash
flows and thus no effect on capital budgeting decisions.
e. 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.
Page 446 Conceptual M/C Chapter 12: Cash Flow and Risk
35. Which of the following statements is CORRECT?
a. Since depreciation is a cash expense, the faster an asset is
depreciated, the lower the projected NPV from investing in the
asset.
b. Under current laws and regulations, corporations must use straight–
line depreciation for all assets whose lives are 5 years or longer.
c. Corporations must use the same depreciation method for both
stockholder reporting and tax purposes.
d. Using accelerated depreciation rather than straight line normally
has the effect of speeding up cash flows and thus increasing a
project’s forecasted NPV.
e. Using accelerated depreciation rather than straight line normally
has the effect of slowing down cash flows and thus reducing a
project’s forecasted NPV.
36. Which of the following statements is CORRECT?
a. 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.
b. Under current laws and regulations, corporations must use straight–
line depreciation for all assets whose lives are 3 years or longer.
c. If they use accelerated depreciation, firms 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.
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 lower than they would
be if straight-line depreciation were required for tax purposes.
e. 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.
37. A company is considering a new project. The CFO plans to calculate the
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 flows), 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 additional investment in net operating 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.
Chapter 12: Cash Flow and Risk Conceptual M/C Page 447
38. Which of the following factors should be included in the cash flows
used to estimate a project’s NPV?
a. All costs associated with the project that have been incurred prior
to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any additional net operating working
capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the
project’s projected cash flows.
e. Expenditures to date on research and development related to the
project, provided those costs have already been expensed for tax
purposes.
39. When evaluating a new project, firms should include in the projected
cash flows all of the following EXCEPT:
a. Changes in net operating working capital attributable to the
project.
b. Previous expenditures associated with a market test to determine the
feasibility of the project, provided those costs have been expensed
for tax purposes.
c. The value of a building owned by the firm that will be used for this
project.
d. A decline in the sales of an existing product, provided that decline
is directly attributable to this project.
e. The salvage value of assets used for the project that will be
recovered at the end of the project’s life.
40. Rowell 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. Rowell owns
the building free and clear–there is no mortgage on it. Which of the
following statements is CORRECT?
a. 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 of the capital budgeting analysis for
any new project.
b. 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.
c. 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.
d. 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.
e. 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.
Page 448 Conceptual M/C Chapter 12: Cash Flow and Risk
41. Which of the following should be considered when a company estimates
the cash flows used to analyze a proposed project?
a. The new project is expected to reduce sales of one of the company’s
existing products by 5%.
b. 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.
c. The company has spent and expensed $1 million on research and
development costs associated with the new project.
d. The company spent and expensed $10 million on a marketing study
before its current analysis regarding whether to accept or reject
the project.
e. 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.
42. Dalrymple Inc. is considering production of 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 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.
b. 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.
c. The company has spent and expensed for tax purposes $3 million on
research related to the new product. These funds cannot be
recovered, but the research may benefit other projects that might be
proposed in the future.
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. However, all of 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.
Chapter 12: Cash Flow and Risk Conceptual M/C Page 449
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?
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 an upward bias in the NPV.
b. 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.
c. The existence of any type of “externality” will reduce the
calculated NPV versus the NPV that would exist without the
externality.
d. 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
proceeds that could be obtained should be charged as a cost to the
project under consideration.
e. 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.
45. 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 firm has a parcel of land that can be used for a new plant site or
be sold, rented, or used for agricultural purposes.
b. 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.
c. A firm must obtain new equipment for the project, and $1 million is
required for shipping and installing the new machinery.
d. A firm has spent $2 million on research and development 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.
e. A firm can produce a new product, and the existence of that product
will stimulate sales of some of the firm’s other products.
Page 450 Conceptual M/C Chapter 12: Cash Flow and Risk
46. 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. 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.
b. Revenues from an existing product would be lost as a result of
customers switching to the new product.
c. Shipping and installation costs associated with a machine that would
be used to produce the new product.
d. 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.
e. 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.
47. A company is considering a proposed new plant that would increase
productive capacity. Which of the following statements is CORRECT?
a. 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.
b. Since depreciation is a non-cash expense, the firm does not need to
deal with depreciation when calculating the operating cash flows.
c. 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.
d. Capital budgeting decisions should be based on before-tax cash flows
because WACC is calculated on a before-tax basis.
e. The WACC used to discount cash flows in a capital budgeting analysis
should be calculated on a before–tax basis. To do otherwise would
bias the NPV upward.
Chapter 12: Cash Flow and Risk Conceptual M/C Page 451
48. Taussig 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
$350,000
$350,000
Standard deviation (σNPV)
$100,000
$150,000
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 stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has the same market risk as Project Y since its cash flows
are not correlated with the cash flows of existing projects.
49. Currently, Powell Products has a beta of 1.0, and its sales and profits
are positively correlated with the overall economy. The company
estimates that a 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 have more stand-alone risk than the
firm’s typical project.
b. The proposed new project would increase the firm’s corporate risk.
c. The proposed new project would increase the firm’s market risk.
d. The proposed new project would not affect the firm’s risk at all.
e. The proposed new project would have less stand-alone risk than the
firm’s typical project.
50. 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 IRR of the project to reflect its greater
risk.
b. Increase the estimated NPV of the project to reflect its greater
risk.
c. Reject the project, since its acceptance would increase the firm’s
risk.
d. Ignore the risk differential if the project would amount to only a
small fraction of the firm’s total assets.
Page 452 Conceptual M/C Chapter 12: Cash Flow and Risk
e. Increase the cost of capital used to evaluate the project to reflect
its higher-than-average risk.
51. Which of the following statements is CORRECT?
a. Sensitivity analysis is a good way to measure market risk because it
explicitly takes into account diversification effects.
b. 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.
c. Well-diversified stockholders do not need to consider market risk
when determining required rates of return.
d. Market risk is important, but it does not have a direct effect on
stock prices because it only affects beta.
e. Simulation analysis is a computerized version of scenario analysis
where input variables are selected randomly on the basis of their
probability distributions.
52. Which of the following statements is CORRECT?
a. Sensitivity analysis as it is generally employed is incomplete in
that it fails to consider the probability of occurrence of the key
input variables.
b. 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.
c. 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.
d. 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.
e. As computer technology advances, simulation analysis becomes
increasingly obsolete and thus less likely to be used than
sensitivity analysis.
53. Langston Labs has an overall (composite) WACC of 10%, which reflects
the cost of capital for its average asset. Its assets vary widely in
risk, and Langston 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?
Chapter 12: Cash Flow and Risk Conceptual M/C Page 453
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.
54. Which of the following procedures does the text say is used most
frequently by businesses when they do capital budgeting analyses?
a. 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.
b. 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.
c. 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.
d. 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 sensitivity analysis, hence simulation is the most
frequently used procedure.
e. 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.
55. Which of the following statements is CORRECT?
a. If an asset is sold for less than its book value at the end of a
project’s life, it will generate a loss for the firm, hence its
terminal cash flow will be negative.
b. Only incremental cash flows are relevant in project analysis, the
proper incremental cash flows are the reported accounting profits,
and thus reported accounting income should be used as the basis for
investor and managerial decisions.
c. It is unrealistic to believe that any increases in net operating
working capital required at the start of an expansion project can be
recovered at the project’s completion. Operating working capital
like inventory is almost always used up in operations. Thus, cash
flows associated with operating working capital should be included
only at the start of a project’s life.
Page 454 Conceptual M/C Chapter 12: Cash Flow and Risk
d. If equipment is expected to be sold for more than its book value at
the end of a project’s life, this will result in a profit. In this
case, despite taxes on the profit, the end-of-project cash flow will
be greater than if the asset had been sold at book value, other
things held constant.
e. Changes in net operating working capital refer to changes in current
assets and current liabilities, not to changes in long–term assets
and liabilities, hence they should not be considered in a capital
budgeting analysis.
Chapter 12: Cash Flow and Risk M/C Problems Page 455
Multiple Choice: Problems
We designated many of these questions EASY or MEDIUM. This indicates that they are not
conceptually hard. However, some of them require a good bit of arithmetic, which will lengthen
the time it takes students to work them. We tried to use constant cash flows, straight-line
depreciation (except where we wanted to illustrate accelerated depreciation), and short project
lives, but completing the cash flow estimation process still requires a good bit of arithmetic.
This should not be important for take-home tests, but it should be considered when making up
timed tests.
56. As assistant to the CFO of Boulder Inc., you must estimate the Year 1
cash flow for a project with the following data. What is the Year 1
cash flow?
Sales revenues $13,000
Depreciation $4,000
Other operating costs $6,000
Tax rate 35.0%
a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568
57. Your company, RMU Inc., is considering a new project whose data are
shown below. What is the project’s Year 1 cash flow?
Sales revenues $22,250
Depreciation $8,000
Other operating costs $12,000
Tax rate 35.0%
a. $ 8,903
b. $ 9,179
c. $ 9,463
d. $ 9,746
e. $10,039
Page 456 M/C Problems Chapter 12: Cash Flow and Risk
58. Clemson Software is considering a new project whose data are shown
below. The required equipment has a 3-year tax life, after which it
will be worthless, and it will be depreciated by the straight-line
method over 3 years. Revenues and other operating costs are expected
to be constant over the project’s 3–year life. What is the project’s
Year 1 cash flow?
Equipment cost (depreciable basis) $65,000
Straight–line depreciation rate 33.333%
Sales revenues, each year $60,000
Operating costs (excl. depreciation) $25,000
Tax rate 35.0%
a. $28,115
b. $28,836
c. $29,575
d. $30,333
e. $31,092
59. As a member of UA Corporation’s financial staff, you must estimate the
Year 1 cash flow for a proposed project with the following data. What
is the Year 1 cash flow?
Sales revenues, each year $42,500
Depreciation $10,000
Other operating costs $17,000
Interest expense $4,000
Tax rate 35.0%
a. $16,351
b. $17,212
c. $18,118
d. $19,071
e. $20,075
60. You work for Whittenerg Inc., which is considering a new project whose
data are shown below. What is the project’s Year 1 cash flow?
Sales revenues, each year $62,500
Depreciation $8,000
Other operating costs $25,000
Interest expense $8,000
Tax rate 35.0%
a. $25,816
b. $27,175
c. $28,534
d. $29,960
e. $31,458