Exam 12: Cash Flow Estimation and Risk Analysis

​Extending the lives of projects with different lives out to a common life for comparison purposes,while theoretically appealing,is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their initial lives.

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.

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.

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.

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.

Rowell 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.Rowell owns the building free and clear: there is no mortgage on it.Which of the following statements is CORRECT?

Replacement chain or EAA analysis is required when analyzing projects that have different lives.This is true regardless of whether the projects are mutually exclusive or independent of one another.​

Which of the following statements is CORRECT?

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.

Desai 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.No change in net operating working capital would be required.This is just one of many projects for the firm,so any losses on this project can be used to offset gains on other firm projects.What is the project's expected NPV?

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?

The relative risk of a proposed project is best accounted for by which of the following procedures?

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?

Foley Systems 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 additional net operating 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 from operations are constant in Years 1 to 3.)

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?

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.

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.

​Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives,it is not used in practice because not projects meet the assumptions the method requires.

Which of the following statements is CORRECT?

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.