Exam 13: Cash Flow Estimation and Risk Analysis

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?

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

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.

Which of the following statements is CORRECT?

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.

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: 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?

Sylvester Media 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? WACC 10.0\% Net investment cost (depreciable basis) \ 200,000 Units sold 50,000 Average price per unit, Year 1 \ 25.00 Fixed op. cost excl. deprec. (constant) \ 150,000 Variable op. cost/unit, Year 1 \ 20.20 Annual depreciation rate 33.333\% Expected inflation 4.00\% Tax rate 35.0\%

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?

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.

Which of the following statements is CORRECT?

Spot-Free Car Wash is considering a new project whose data are shown below.The equipment to be used has a 3-year tax life,would be depreciated on a straight-line basis over the project's 3-year life,and would have a zero salvage value after Year 3.No new working capital would be required.Revenues and other operating costs will be constant over the project's life,and this is just one of the firm's many projects,so any losses on it can be used to offset profits in other units.If the number of cars washed declined by 40% from the expected level,by how much would the project's NPV decline? (Hint: Note that cash flows are constant at the Year 1 level,whatever that level is.) WACC 10.0\% Net investment cost (depreciable basis) \ 60,000 Number of cars washed 2,800 Average price per car \ 25.00 Fixed op. cost (excl. deprec.) \ 10,000 Variable op. costunit (i.e., VC per car washed) \ 5.375 Annual depreciation \ 20,000 Tax rate 35.0\%

Which of the following rules is CORRECT for capital budgeting analysis?

Which of the following statements is CORRECT?

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.

Garden-Grow Products is considering a new investment whose data are shown below.The equipment would be depreciated on a straight-line basis over the project's 3-year life,would have a zero salvage value,and would require some additional working capital that 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 life.What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.) WACC 10.0\% Net investment in fixed assets (basis) \ 75,000 Required new working capital \ 15,000 Straight-line deprec. rate 33.333\% Sales revenues, each year \ 75,000 Operating costs (excl. deprec.), each year \ 25,000 Tax rate 35.0\%

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 procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

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.

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.