Exam 12: Cash Flow Estimation and Risk Analysis

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 change in net operating 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.)

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

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.

Which of the following statements is CORRECT?

​Atlas Corp.is considering two mutually exclusive projects.Both require an initial investment of $10,000 at t = 0.Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2,respectively.Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next 4 years.Each project has a WACC of 9.25%,and Project S can be repeated with no changes in its cash flows.The controller prefers Project S,but the CFO prefers Project L.How much value will the firm gain or lose if Project L is selected over Project S,i.e.,what is the value of NPV_L - NPV_S?

Temple Corp.is considering a new project whose data are shown below.The equipment that would be used has a 3-year tax life,would be depreciated by the straight-line method over its 3-year life,and would have a zero salvage value.No change in net operating working capital would be required.Revenues and other operating costs are expected to be constant over the project's 3-year life.What is the project's NPV?

The two cardinal rules that financial analysts should follow to avoid 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 for capital budgeting projects.

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

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.

​Mulroney Corp.is considering two mutually exclusive projects.Both require an initial investment of $10,000 at t = 0.Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,800 at the end of Years 1 and 2,respectively.In addition,Project X can be repeated at the end of Year 2 with no changes in its cash flows.Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years.Each project has a WACC of 8%.Using the replacement chain approach,what is the NPV of the most profitable project?

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 for capital budgeting projects.

Fool Proof Software is considering a new project whose data are shown below.The equipment that would be used has a 3-year tax life,and the allowed depreciation 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 life.What is the Year 1 cash flow?

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.

Suppose Tapley Inc.uses a WACC of 8% for below-average risk projects,10% for average-risk projects,and 12% for above-average risk projects.Which of the following independent projects should Tapley accept,assuming that the company uses the NPV method when choosing projects?

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.

Liberty Services is now at the end of the final year of a project.The equipment originally cost $22,500,of which 75% has been depreciated.The firm can sell the used equipment today for $6,000,and its tax rate is 40%.What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value,the firm will receive a tax credit as a result of the sale.

The two methods discussed in the text for dealing with unequal project lives are (1)the replacement chain approach and (2)the equivalent annual annuity (EAA)approach.

Which of the following factors should be included in the cash flows used to estimate a project's NPV?

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.