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Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk 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.
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 Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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
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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
38. Other things held constant, which of the following would increase the NPV of a project being considered?
a.
A shift from straight-line to MACRS depreciation.
b.
Making the initial investment in the first year rather than spreading it over the first three years.
c.
An increase in the discount rate associated with the project.
d.
An increase in required net operating working capital.
e.
The project would decrease sales of another product line.
39. 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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
40. 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.
41. 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
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
42. 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.
43. 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
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
44. 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.
Chapter 12: Cash Flow Estimation and Risk Analysis
45. 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.
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.
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.
