Exam 11: Cash Flow Estimation and Risk Analysis

When evaluating a new project, which statement should firms NOT include in the projected cash flows?

Sometimes analysts think that an externality is present in a project, but they recognize that the particular externality cannot be quantified with any precision-estimates of its effect would really just be guesses. In such a situation, 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 actually is.

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected sales include sales that will be taken away from another of Walker's books. The lost sales on the existing book are a sunk cost and as such should not be considered in the analysis of the new book.

Which of the following statements is correct?

Laurier Inc., a household products firm, is considering production of a new detergent. In evaluating whether to go ahead with the project, which item should NOT be explicitly considered when cash flows are estimated?

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, the project's initial outlays and subsequent costs for large projects can be forecasted with great accuracy.

When the cash flows for a project are estimated, interest payments should be included if debt is to be used to help finance the project.

California Hideaways is considering a new project whose data are shown below. The equipment has a 4-year project life. This equipment falls into class 43 with a CCA rate of 30% and would have zero salvage value. No new working capital would be required. Revenues and cash operating costs are expected to be constant over the project's 4-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 4.) WACC10.0% Net investment cost$65,000 Sales revenues, each year$60,000 Cash operating costs$25,000 Tax rate35.0%

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales. Other things held constant, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the more risky the project.

Rocky Top Car Wash 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 the project's 3-year life, and would have zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. If the number of cars washed declined by 50% from the expected level, by how much would the project's NPV change? (Hint: Cash flows are constant in Years 1 to 3.) WACC10.0% Net capital investment cost$60,000 Number of cars washed2,800 Average price per car$25.00 Fixed cash operating cost$10,000 Variable op. cost/unit (i.e., per car washed)$5.357 Annual capital cost allowance$20,000 Tax rate35.0%

Your company, Q4 Inc., is considering a new project whose data are shown below. The required equipment has an economic year of 5 years, and has a CCA rate of 30% in class 10. Revenues and cash operating costs are expected to be constant over the project's 5-year operating life. What is the project's net operating cash flow during Year 2? Equipment cost$70,000 Sales revenues (each year)$50,000 Cash operating costs (each year)$25,000 Tax rate35.0%

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

Which factor is NOT relevant when determining incremental cash flows for a new product?

Bing Services is now in the final year of a project. The equipment originally cost $20,000. The existing UCC is $5,000. Bing can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment's net after-tax salvage value for use in a capital budgeting analysis? Note that the recapture is fully taxable.

Any cash flow that can be classified as incremental to a particular project is relevant in a capital budgeting analysis.

Which of the following statements best describes a sunk cost?

As a member of Midwest Corporation's financial staff, you must estimate the Year 1 operating cash flow for a proposed project with the following data. What is the Year 1 net operating cash flow? Sales revenues, each year$35,000 Capital cost allowance$10,000 Cash operating costs$17,000 Interest expense$4,000 Tax rate35.0%

Which of the following statements regarding CCA is true?

Which item should be considered when a company estimates the cash flows used to analyze a proposed project?

In cash flow estimation, the existence of externalities must be taken into account if those externalities have any effects on the firm's cash flows.