Exam 12: Cash Flow Estimation and Risk Analysis

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.

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.

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? Equipment cost (depreciable basis) \ 65,000 Straight-line depreciation rate 33.333\% Sales revenues, each year \ 60,000 Operating costs (excl. depreciation) \ 25,000 Tax rate 35.0\% a. $\$ 28,115$ b. $\$ 28,836$ c. $\$ 29,575$ d. $\$ 30,333$ e. $\$ 31,092$

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.

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 \ 22,250 Depreciation \ 8,000 Other operating costs \ 12,000 Tax rate 35.0\% a. $\$ 8,903$ b. $\$ 9,179$ c. $\$ 9,463$ d. $\$ 9,746$ e. $\$ 10,039$

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.

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.

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: A High 15\% B Average 12\% C High 11\% D Low 9\% E Low 6\% Which set of projects would maximize shareholder wealth?

Which of the following statements is CORRECT?

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.

Which of the following statements is CORRECT?

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?

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?

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

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

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? Sales revenues, each year \ 42,500 Depreciation \ 10,000 Other operating costs \ 17,000 Interest expense \ 4,000 Tax rate 35.0\% a. $\$ 16,351$ b. $\$ 17,212$ c. $\$ 18,118$ d. $\$ 19,071$ e. $\$ 20,075$

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.

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

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.

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.