Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  Only incremental cash flows are relevant in project analysis,the proper incremental cash flows are the reported accounting profits,and thus reported accounting income should be used as the basis for investor and managerial decisions. 
B)  It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion.Working capital like inventory is almost always used up in operations.Thus,cash flows associated with working capital should be included only at the start of a project's life. 
C)  If equipment is expected to be sold for more than its book value at the end of a project's life,this will result in a profit.In this case,despite taxes on the profit,the end-of-project cash flow will be greater than if the asset had been sold at book value,other things held constant. 
D)  Changes in net working capital refer to changes in current assets and current liabilities,not to changes in long-term assets and liabilities.Therefore,changes in net working capital should not be considered in a capital budgeting analysis. 
E)  If an asset is sold for less than its book value at the end of a project's life,it will generate a loss for the firm,hence its terminal cash flow will be negative. 
A)  Only incremental cash flows are relevant in project analysis,the proper incremental cash flows are the reported accounting profits,and thus reported accounting income should be used as the basis for investor and managerial decisions. 
B)  It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion.Working capital like inventory is almost always used up in operations.Thus,cash flows associated with working capital should be included only at the start of a project's life. 
C)  If equipment is expected to be sold for more than its book value at the end of a project's life,this will result in a profit.In this case,despite taxes on the profit,the end-of-project cash flow will be greater than if the asset had been sold at book value,other things held constant. 
D)  Changes in net working capital refer to changes in current assets and current liabilities,not to changes in long-term assets and liabilities.Therefore,changes in net working capital should not be considered in a capital budgeting analysis. 
E)  If an asset is sold for less than its book value at the end of a project's life,it will generate a loss for the firm,hence its terminal cash flow will be negative.

Question 2

When evaluating a new project,firms should include in the projected cash flows all of the following EXCEPT:

Accepted Answer

A)  Previous expenditures associated with a market test to determine the feasibility of the project,provided those costs have been expensed for tax purposes. 
B)  The value of a building owned by the firm that will be used for this project. 
C)  A decline in the sales of an existing product,provided that decline is directly attributable to this project. 
D)  The salvage value of assets used for the project that will be recovered at the end of the project's life. 
E)  Changes in net working capital attributable to the project. 
A)  Previous expenditures associated with a market test to determine the feasibility of the project,provided those costs have been expensed for tax purposes. 
B)  The value of a building owned by the firm that will be used for this project. 
C)  A decline in the sales of an existing product,provided that decline is directly attributable to this project. 
D)  The salvage value of assets used for the project that will be recovered at the end of the project's life. 
E)  Changes in net working capital attributable to the project.

Question 3

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

Accepted Answer

A)  Only incremental cash flows,which are the cash flows that would result if a project is accepted,are relevant when making accept/reject decisions. 
B)  Sunk costs are not included in the annual cash flows,but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. 
C)  A proposed project's estimated net income as determined by the firm's accountants,using generally accepted accounting principles (GAAP),is discounted at the WACC,and if the PV of this income stream exceeds the project's cost,the project should be accepted. 
D)  If a product is competitive with some of the firm's other products,this fact should be incorporated into the estimate of the relevant cash flows.However,if the new product is complementary to some of the firm's other products,this fact need not be reflected in the analysis. 
E)  The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows. 
A)  Only incremental cash flows,which are the cash flows that would result if a project is accepted,are relevant when making accept/reject decisions. 
B)  Sunk costs are not included in the annual cash flows,but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. 
C)  A proposed project's estimated net income as determined by the firm's accountants,using generally accepted accounting principles (GAAP),is discounted at the WACC,and if the PV of this income stream exceeds the project's cost,the project should be accepted. 
D)  If a product is competitive with some of the firm's other products,this fact should be incorporated into the estimate of the relevant cash flows.However,if the new product is complementary to some of the firm's other products,this fact need not be reflected in the analysis. 
E)  The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

To increase productive capacity,a company is considering a proposed new plant.Which of the following statements is CORRECT?

Accepted Answer

A)  Since depreciation is a non-cash expense,the firm does not need to deal with depreciation when calculating the operating cash flows. 
B)  When estimating the project's operating cash flows,it is important to include both opportunity costs and sunk costs,but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. 
C)  Capital budgeting decisions should be based on before-tax cash flows. 
D)  The cost of capital used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. 
E)  In calculating the project's operating cash flows,the firm should not deduct financing costs such as interest expense,because financing costs are accounted for by discounting at the cost of capital.If interest were deducted when estimating cash flows,this would,in effect,"double count" it. 
A)  Since depreciation is a non-cash expense,the firm does not need to deal with depreciation when calculating the operating cash flows. 
B)  When estimating the project's operating cash flows,it is important to include both opportunity costs and sunk costs,but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. 
C)  Capital budgeting decisions should be based on before-tax cash flows. 
D)  The cost of capital used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. 
E)  In calculating the project's operating cash flows,the firm should not deduct financing costs such as interest expense,because financing costs are accounted for by discounting at the cost of capital.If interest were deducted when estimating cash flows,this would,in effect,"double count" it.

Question 6

The coefficient of variation,calculated as the standard deviation of expected returns divided by the expected return,is a standardized measure of the risk per unit of expected return.

Accepted Answer

A) True 
 B)False

Question 7

If a firm's projects differ in risk,then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

Accepted Answer

A) True 
 B)False

Question 8

Kasper Film Co.is selling off some old equipment it no longer needs because its associated project has come to an end.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.

Accepted Answer

A)  $5,558 
B)  $5,850 
C)  $6,143 
D)  $6,450 
E)  $6,772 
A)  $5,558 
B)  $5,850 
C)  $6,143 
D)  $6,450 
E)  $6,772

Question 9

Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets,not working capital.

Accepted Answer

A) True 
 B)False

Question 10

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?

Accepted Answer

A)  All sunk costs that have been incurred relating to the project. 
B)  All interest expenses on debt used to help finance the project. 
C)  The investment in working capital required to operate the project,even if that investment will be recovered at the end of the project's life. 
D)  Sunk costs that have been incurred relating to the project,but only if those costs were incurred prior to the current year. 
E)  Effects of the project on other divisions of the firm,but only if those effects lower the project's own direct cash flows. 
A)  All sunk costs that have been incurred relating to the project. 
B)  All interest expenses on debt used to help finance the project. 
C)  The investment in working capital required to operate the project,even if that investment will be recovered at the end of the project's life. 
D)  Sunk costs that have been incurred relating to the project,but only if those costs were incurred prior to the current year. 
E)  Effects of the project on other divisions of the firm,but only if those effects lower the project's own direct cash flows.

Question 11

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

Accepted Answer

A) True 
 B)False

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

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?

Accepted Answer

A)  Increase the estimated NPV of the project to reflect its greater risk. 
B)  Reject the project,since its acceptance would increase the firm's risk. 
C)  Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. 
D)  Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. 
E)  Increase the estimated IRR of the project to reflect its greater risk. 
A)  Increase the estimated NPV of the project to reflect its greater risk. 
B)  Reject the project,since its acceptance would increase the firm's risk. 
C)  Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. 
D)  Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. 
E)  Increase the estimated IRR of the project to reflect its greater risk.

Question 14

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?

Accepted Answer

A)  Revenues from an existing product would be lost as a result of customers switching to the new product. 
B)  Shipping and installation costs associated with a machine that would be used to produce the new product. 
C)  The cost of a study relating to the market for the new product that was completed last year.The results of this research were positive,and they led to the tentative decision to go ahead with the new product.The cost of the research was incurred and expensed for tax purposes last year. 
D)  It is learned that land the company owns and would use for the new project,if it is accepted,could be sold to another firm. 
E)  Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product.This space could be used for other products if it is not used for the project under consideration. 
A)  Revenues from an existing product would be lost as a result of customers switching to the new product. 
B)  Shipping and installation costs associated with a machine that would be used to produce the new product. 
C)  The cost of a study relating to the market for the new product that was completed last year.The results of this research were positive,and they led to the tentative decision to go ahead with the new product.The cost of the research was incurred and expensed for tax purposes last year. 
D)  It is learned that land the company owns and would use for the new project,if it is accepted,could be sold to another firm. 
E)  Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product.This space could be used for other products if it is not used for the project under consideration.

Question 15

While developing a new product line,Cook 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.Cook owns the building free and clear⎯there is no mortgage on it.Which of the following statements is CORRECT?

Accepted Answer

A)  If the building could be sold,then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. 
B)  This is an example of an externality,because the very existence of the building affects the cash flows for any new project that Rowell might consider. 
C)  Since the building was built in the past,its cost is a sunk cost and thus need not be considered when new projects are being evaluated,even if it would be used by those new projects. 
D)  If there is a mortgage loan on the building,then the interest on that loan would have to be charged to any new project that used the building. 
E)  Since the building has been paid for,it can be used by another project with no additional cost.Therefore,it should not be reflected in the cash flows for any new project. 
A)  If the building could be sold,then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. 
B)  This is an example of an externality,because the very existence of the building affects the cash flows for any new project that Rowell might consider. 
C)  Since the building was built in the past,its cost is a sunk cost and thus need not be considered when new projects are being evaluated,even if it would be used by those new projects. 
D)  If there is a mortgage loan on the building,then the interest on that loan would have to be charged to any new project that used the building. 
E)  Since the building has been paid for,it can be used by another project with no additional cost.Therefore,it should not be reflected in the cash flows for any new project.

Question 16

Wansley Enterprises is considering a new project.The company has a beta of 1.0,and its sales and profits are positively correlated with the overall economy.The company estimates that the 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?

Accepted Answer

A)  The proposed new project would increase the firm's corporate risk. 
B)  The proposed new project would increase the firm's market risk. 
C)  The proposed new project would not affect the firm's risk at all. 
D)  The proposed new project would have less stand-alone risk than the firm's typical project. 
E)  The proposed new project would have more stand-alone risk than the firm's typical project. 
A)  The proposed new project would increase the firm's corporate risk. 
B)  The proposed new project would increase the firm's market risk. 
C)  The proposed new project would not affect the firm's risk at all. 
D)  The proposed new project would have less stand-alone risk than the firm's typical project. 
E)  The proposed new project would have more stand-alone risk than the firm's typical project.

Question 17

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

Accepted Answer

A)  Shipping and installation costs. 
B)  Cannibalization effects. 
C)  Opportunity costs. 
D)  Sunk costs that have been expensed for tax purposes. 
E)  Changes in net working capital. 
A)  Shipping and installation costs. 
B)  Cannibalization effects. 
C)  Opportunity costs. 
D)  Sunk costs that have been expensed for tax purposes. 
E)  Changes in net working capital.

Question 18

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.

Accepted Answer

A) True 
 B)False

Question 19

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

A) True 
 B)False

Question 20

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.

Accepted Answer

A) True 
 B)False

Exam 11: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

When evaluating a new project,firms should include in the projected cash flows all of the following EXCEPT:

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

To increase productive capacity,a company is considering a proposed new plant.Which of the following statements is CORRECT?

The coefficient of variation,calculated as the standard deviation of expected returns divided by the expected return,is a standardized measure of the risk per unit of expected return.

If a firm's projects differ in risk,then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets,not working capital.

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

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?

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?

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

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.

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

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.

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Risk and Return

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Financial Planning and Applications to Corporate Valuation

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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