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Chapter 12: Cash Flow Estimation and Risk Analysis
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.
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.
48. 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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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.
49. 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 ( NPV)
$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.
Chapter 12: Cash Flow Estimation and Risk Analysis
50. 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.
51. 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.
e.
Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
Chapter 12: Cash Flow Estimation and Risk Analysis
52. 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.
53. 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.
Chapter 12: Cash Flow Estimation and Risk Analysis
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. 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%
Chapter 12: Cash Flow Estimation and Risk Analysis
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
56. 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.
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 Estimation and Risk Analysis
57. Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated
depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce
a.
Higher depreciation charges in the early years of an asset's life.
b.
Larger cash flows in the earlier years of an asset's life.
c.
Larger total undiscounted profits from the project over the project's life.
d.
Smaller accounting profits in the early years, assuming the company uses the same depreciation method for
tax and book purposes.
e.
Lower tax payments in the earlier years of an asset's life.
58. 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
$25,750
Depreciation
$8,000
Other operating costs
$12,000
Tax rate
35.0%
a.
$10,329
b.
$10,681
c.
$13,029
d.
$11,738
e.
$11,151
Chapter 12: Cash Flow Estimation and Risk Analysis
59. 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? Do not round the intermediate calculations and round the final answer to the nearest whole
number.
Sales revenues
$12,500
Depreciation
$4,000
Other operating costs
$6,000
Tax rate
35.0%
a.
$5,625
b.
$4,275
c.
$4,388
d.
$5,456
e.
$4,669
Chapter 12: Cash Flow Estimation and Risk Analysis
60. 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? Do
not round the intermediate calculations and round the final answer to the nearest whole number.
Equipment cost (depreciable basis)
$62,000
Straight-line depreciation rate
33.333%
Sales revenues, each year
$60,000
Operating costs (excl. depr.)
$25,000
Tax rate
35.0%
a.
$23,387
b.
$33,881
c.
$35,081
d.
$29,684
e.
$29,983
Chapter 12: Cash Flow Estimation and Risk Analysis
61. 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? Do not round the intermediate calculations and round the final answer
to the nearest whole number.
Sales revenues, each year
$49,000
Depreciation
$10,000
Other operating costs
$17,000
Interest expense
$4,000
Tax rate
35.0%
a.
$20,615
b.
$20,398
c.
$19,313
d.
$21,700
e.
$18,011
Chapter 12: Cash Flow Estimation and Risk Analysis
62. Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has
a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4.
Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1
cash flow?
Equipment cost (depreciable basis)
$90,000
Sales revenues, each year
$60,000
Operating costs (excl. depr.)
$25,000
Tax rate
35.0%
a.
$34,802
b.
$24,859
c.
$33,145
d.
$28,836
e.
$27,179
Chapter 12: Cash Flow Estimation and Risk Analysis
63. 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
$62,750
Depreciation
$8,000
Other operating costs
$25,000
Interest expense
$8,000
Tax rate
35.0%
a.
$27,229
b.
$24,573
c.
$22,138
d.
$21,473
e.
$26,122
Chapter 12: Cash Flow Estimation and Risk Analysis
64. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a
3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues
and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the
project's Year 4 cash flow?
Equipment cost (depreciable basis)
$70,000
Sales revenues, each year
$47,000
Operating costs (excl. depr.)
$25,000
Tax rate
35.0%
a.
$12,332
b.
$16,335
c.
$16,015
d.
$14,093
e.
$13,132
Chapter 12: Cash Flow Estimation and Risk Analysis
65. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-
year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value.
No change in net operating working capital would be required. Revenues and other operating costs are expected to be
constant over the project's 3-year life. What is the project's NPV? Do not round the intermediate calculations and round
the final answer to the nearest whole number.
Risk-adjusted WACC
10.0%
Net investment cost (depreciable basis)
$65,000
Straight-line depr. rate
33.3333%
Sales revenues, each year
$63,000
Annual operating costs (excl. depr.)
$25,000
Tax rate
35.0%
a.
$14,825
b.
$12,838
c.
$18,340
d.
$15,283
e.
$17,729
