Chapter 11: 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
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
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
Chapter 11: 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
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
Chapter 11: Cash Flow Estimation and Risk Analysis
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
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
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
Chapter 11: 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
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
Chapter 11: Cash Flow Estimation and Risk Analysis
11. 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.
a. True
12. 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
13. 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.
a. True
Chapter 11: Cash Flow Estimation and Risk Analysis
14. 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
15. 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
16. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital
budgeting project?
Chapter 11: Cash Flow Estimation and Risk Analysis
a. Shipping and installation costs.
b. Cannibalization effects.
c. Opportunity costs.
d. Sunk costs that have been expensed for tax purposes.
17. 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.
18. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
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
19. 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
20. 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.
Chapter 11: Cash Flow Estimation and Risk Analysis
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
21. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
22. 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.
23. 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.
24. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
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
25. 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.
Chapter 11: Cash Flow Estimation and Risk Analysis
26. 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
27. 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.
Chapter 11: Cash Flow Estimation and Risk Analysis
28. 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
29. 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.
Chapter 11: Cash Flow Estimation and Risk Analysis
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
30. 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
31. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
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
32. 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.
a. True
33. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
34. 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
35. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
36. 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
37. 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
38. 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.
a. True
Chapter 11: Cash Flow Estimation and Risk Analysis
39. 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
40. 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
Chapter 11: Cash Flow Estimation and Risk Analysis
41. 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
42. 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,
Chapter 11: Cash Flow Estimation and Risk Analysis
43. 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 cost of capital 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 cost of capital. If interest were deducted when
44. Which of the following statements is CORRECT?
a. 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.
b. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can
be recovered at the project’s completion. Working capital like inventory is almost always used up in operations. Thus,
cash flows associated with working capital should be included only at the start of a project’s life.
c. 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.
d. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-
term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting
analysis.