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Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
Copyright Cengage Learning. Powered by Cognero.
Page 1
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
ANSWER:
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
ANSWER:
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.
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
a.
True
b.
False
ANSWER:
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
ANSWER:
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
ANSWER:
True
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
ANSWER:
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
ANSWER:
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
b.
False
ANSWER:
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
ANSWER:
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
b.
False
ANSWER:
False
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
b.
False
ANSWER:
False
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
b.
False
ANSWER:
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
b.
False
ANSWER:
False
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Page 7
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
b.
False
ANSWER:
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
b.
False
ANSWER:
False
16. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
budgeting project?
a.
Shipping and installation costs.
b.
Cannibalization effects.
c.
Opportunity costs.
d.
Sunk costs that have been expensed for tax purposes.
e.
Changes in net working capital.
ANSWER:
d
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.
e.
A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
ANSWER:
b
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
decline in deposits of the bank's other offices.
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
depleted.
ANSWER:
c
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 operations. If the project would have a favorable effect on other operations, then this is not an
externality.
ANSWER:
a
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Page 10
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.
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 competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
ANSWER:
d
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.
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
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
flows.
ANSWER:
c
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.
e.
All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
ANSWER:
b
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.
e.
Changes in net working capital attributable to the project.
ANSWER:
a
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
owns the building free and clear⎯there is no mortgage on it. Which of the following statements is CORRECT?
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 not be reflected in the cash flows for any new project.
ANSWER:
a
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Page 13
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.
e.
The new project is expected to reduce sales of one of the company's existing products by 5%.
ANSWER:
e
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
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
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 products.
ANSWER:
b
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.
e.
The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash
flows.
ANSWER:
a
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 to include interest expense as a cost when determining the project's cash flows will lead to an upward
bias in the NPV.
ANSWER:
c
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.
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
purposes.
ANSWER:
c
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
product. This space could be used for other products if it is not used for the project under consideration.
ANSWER:
c
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
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.
ANSWER:
a
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
b.
False
ANSWER:
False
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
b.
False
ANSWER:
False
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
b.
False
ANSWER:
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
b.
False
ANSWER:
False
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
b.
False
ANSWER:
True
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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
b.
False
ANSWER:
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
b.
False
ANSWER:
False
