Exam 11: Cash Flow Estimation and Risk Analysis

Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?

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?

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.

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.

Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight- line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

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.

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.

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.

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?

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.

Which of the following statements is CORRECT?

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.

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.

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

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.

Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

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?

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.

TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight- line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

Which of the following statements is CORRECT?