CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
48. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the
capital budgeting analysis for a new product?
a.
Revenues from an existing product would be lost as a result of customers switching to the new product.
b.
Shipping and installation costs associated with a machine that would be used to produce the new product.
c.
The cost of a study relating to the market for the new product that was completed last year. The results of this
research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the
research was incurred and expensed for tax purposes last year.
d.
It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to
another firm.
e.
Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new
product. This space could be used for other products if it is not used for the project under consideration.
c
Difficulty: Moderate
INTE.GENE.16.84 – LO: 13-1
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forecasting, and cash flows
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Incremental cash flows
TYPE: Multiple Choice: Conceptual
49. Which of the following statements is CORRECT?
a.
An example of an externality is a situation where a bank opens a new office, and that new office causes
deposits in the bank’s other offices to increase.
b.
The NPV method automatically deals correctly with externalities, even if the externalities are not specifically
identified, but the IRR method does not. This is another reason to favor the NPV.
c.
Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically
identified. However, the payback method does not.
d.
Identifying an externality can never lead to an increase in the calculated NPV.
e.
An externality is a situation where a project would have an adverse effect on some other part of the firm’s
overall operations. If the project would have a favorable effect on other operations, then this is not an
externality.
a
Difficulty: Moderate
INTE.GENE.16.84 – LO: 13-1
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United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
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Externalities
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
50. To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is
CORRECT?
a.
Since depreciation is a non–cash expense, the firm does not need to deal with depreciation when calculating
the operating cash flows.
b.
When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk
costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the
discounting process.
c.
Capital budgeting decisions should be based on before-tax cash flows.
d.
The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax
basis.
e.
In calculating the project’s operating cash flows, the firm should not deduct financing costs such as interest
expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted
when estimating cash flows, this would, in effect, “double count” it.
Difficulty: Moderate
INTE.GENE.16.85 – LO: 13-2
United States – BUSPROG: Analytic
capital
United States – AK – Tier 2: Financial statements, an – Tier 2: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
51. Tallant Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company
estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted
thorough scenario and simulation analyses. This research produced the following data:
Project Y
Expected NPV
$500,000
Standard deviation (σNPV)
$250,000
Project beta (vs. market)
0.8
Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with
the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.
Which of the following statements is CORRECT?
a.
Project X has more corporate (or within-firm) risk than Project Y.
b.
Project X has more market risk than Project Y.
c.
Project X has the same level of corporate risk as Project Y.
d.
Project X has less market risk than Project Y.
e.
Project X has more stand-alone risk than Project Y.
TYPE: Multiple Choice: Conceptual
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
52. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are
positively correlated with the overall economy. The company estimates that the proposed new project would have a higher
standard deviation and coefficient of variation than an average company project. Also, the new project’s sales would be
countercyclical in the sense that they would be high when the overall economy is down and low when the overall
economy is strong. On the basis of this information, which of the following statements is CORRECT?
a.
The proposed new project would increase the firm’s corporate risk.
b.
The proposed new project would increase the firm’s market risk.
c.
The proposed new project would not affect the firm’s risk at all.
d.
The proposed new project would have less stand-alone risk than the firm’s typical project.
e.
The proposed new project would have more stand-alone risk than the firm’s typical project.
Difficulty: Moderate
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United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Risk analysis
TYPE: Multiple Choice: Conceptual
53. A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all
methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the
following?
a.
Increase the estimated NPV of the project to reflect its greater risk.
Difficulty: Moderate
INTE.GENE.16.86 – LO: 13-3
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Risk analysis
TYPE: Multiple Choice: Conceptual
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
b.
Reject the project, since its acceptance would increase the firm’s risk.
c.
Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
d.
Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
e.
Increase the estimated IRR of the project to reflect its greater risk.
Difficulty: Moderate
INTE.GENE.16.86 – LO: 13-3
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Project’s effect on firm risk
TYPE: Multiple Choice: Conceptual
54. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%,
which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk
projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering
the following projects:
Risk
Expected Return
High
15%
Average
12%
High
11%
Low
9%
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.
Difficulty: Moderate
INTE.GENE.16.86 – LO: 13-3
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
55. Which of the following statements is CORRECT?
a.
One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the
probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
b.
Well-diversified stockholders do not need to consider market risk when determining required rates of return.
c.
Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
d.
Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly
on the basis of their probability distributions.
e.
Sensitivity analysis is a good way to measure market risk because it explicitly takes into account
diversification effects.
Difficulty: Moderate
INTE.GENE.16.89 – LO: 13-7
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Sensitivity, scenario, & sim.
TYPE: Multiple Choice: Conceptual
56. Which of the following statements is CORRECT?
a.
In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less
risky, because a small error in estimating a variable such as unit sales would produce only a small error in the
project’s NPV.
b.
The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a
relatively powerful computer, coupled with an efficient financial planning software package, whereas
simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a
calculator.
c.
Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input
variables and the probability of occurrence of these variables’ values.
d.
As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to
be used as compared to sensitivity analysis.
e.
Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of
occurrence of the key input variables.
Difficulty: Moderate
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
capital
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Risk-adjusted discount rate
TYPE: Multiple Choice: Conceptual
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
57. Which of the following procedures does the text say is used most frequently by businesses when they do capital
budgeting analyses?
a.
Differential project risk cannot be accounted for by using “risk-adjusted discount rates” because it is highly
subjective and difficult to justify. It is better to not risk adjust at all.
b.
Other things held constant, if returns on a project are thought to be positively correlated with the returns on
other firms in the economy, then the project’s NPV will be found using a lower discount rate than would be
appropriate if the project’s returns were negatively correlated.
c.
Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to
determine a trial NPV, and a number of trial NPVs are averaged to find the project’s expected NPV. Sensitivity
and scenario analyses, on the other hand, require much more information regarding the input variables,
including probability distributions and correlations among those variables. This makes it easier to implement a
simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used
procedure.
d.
DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital
budgeting projects are not passive investments⎯managers can often take positive actions after the investment
has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real
options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project’s real
options must be considered separately.
e.
The firm’s corporate, or overall, WACC is used to discount all project cash flows to find the projects’ NPVs.
Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down
to adjust for differential risk.
Difficulty: Moderate
INTE.GENE.16.89 – LO: 13-7
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Risk adjustment
TYPE: Multiple Choice: Conceptual
58. 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
INTE.GENE.16.89 – LO: 13-7
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Sensitivity, scenario, & sim.
TYPE: Multiple Choice: Conceptual
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
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.
e.
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.
c
Difficulty: Moderate
INTE.GENE.16.85 – LO: 13-2
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CFs and accounting measures
TYPE: Multiple Choice: Conceptual
59. You have just landed an internship in the CFO’s office of Hawkesworth Inc. Your first task is to estimate the Year 1
cash flow for a project with the following data. What is the Year 1 cash flow?
Sales revenues
Depreciation
Other operating costs
Tax rate
a.
$5,950
b.
$6,099
c.
$6,251
d.
$6,407
e.
$6,568
a
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
60. In your first job with TBL Inc. your task is to consider a new project whose data are shown below. What is the
project’s Year 1 cash flow?
Sales revenues
Depreciation
Other operating costs
Tax rate
a.
$8,903
b.
$9,179
c.
$9,463
d.
$9,746
e.
$10,039
c
Difficulty: Easy
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Annual CF
Difficulty: Easy
INTE.GENE.16.85 – LO: 13-2
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Annual CF
TYPE: Multiple Choice: Problem
answer.
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
61. Fitzgerald Computers 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)
Straight-line depreciation rate
Sales revenues, each year
Operating costs (excl. deprec.)
Tax rate
a.
$28,115
b.
$28,836
c.
$29,575
d.
$30,333
e.
$31,092
Difficulty: Easy
INTE.GENE.16.85 – LO: 13-2
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forecasting, and cash flows
United States – OH – Default City – TBA
Annual CF
TYPE: Multiple Choice: Problem
TYPE: Multiple Choice: Problem
answer.
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
62. VR Corporation has the opportunity to invest in a new project, the details of which are shown below. What is the Year
1 cash flow for the project?
Sales revenues, each year
Depreciation
Other operating costs
Interest expense
Tax rate
a.
$16,351
b.
$17,212
c.
$18,118
d.
$19,071
e.
$20,075
e
Difficulty: Easy
INTE.GENE.16.85 – LO: 13-2
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forecasting, and cash flows
United States – OH – Default City – TBA
Annual CF
TYPE: Multiple Choice: Problem
answer.
63. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What is the
project’s Year 1 cash flow?
Sales revenues, each year
Depreciation
Other operating costs
Interest expense
Tax rate
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
a.
$25,816
b.
$27,175
c.
$28,534
d.
$29,960
e.
$31,458
64. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of
30%. What is the project’s coefficient of variation?
a.
1.20
b.
1.26
c.
1.32
d.
1.39
e.
1.46
a
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
65. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What
is the investment’s coefficient of variation?
a.
0.67
b.
0.73
c.
0.81
d.
0.89
e.
0.98
a
Difficulty: Easy
INTE.GENE.16.87 – LO: 13-6
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Coefficient of variation
TYPE: Multiple Choice: Problem
66. Your new employer, Freeman 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 33.33%, 44.45%,
14.81%, and 7.41% 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)
Sales revenues, each year
Operating costs (excl. deprec.)
Tax rate
a.
$30,333
b.
$31,849
c.
$33,442
d.
$35,114
e.
$36,869
a
INTE.GENE.16.87 – LO: 13-6
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United States – AK – DISC: Risk and return
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Coefficient of variation
TYPE: Multiple Choice: Problem
CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
67. Whitestone Products 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 33.33%, 44.45%, 14.81%, and 7.41% 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)
Sales revenues, each year
Operating costs (excl. deprec.)
Tax rate
a.
$11,904
b.
$12,531
c.
$13,190
d.
$13,850
e.
$14,542
c
Difficulty: Moderate
INTE.GENE.16.85 – LO: 13-2
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United States – OH – Default City – TBA
TYPE: Multiple Choice: Problem