Exam 11: Cash Flow Estimation and Risk Analysis

The change in net operating working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is true for both expansion and replacement projects.

Capital cost allowance (CCA) rates are based on the declining balance for tax calculation.

Majestic Theaters is considering investing in some new projection equipment whose data are shown below. The required equipment has a 7-year project life falling into a CCA class of 30%, but it would have a positive pre-tax salvage value at the end of Year 7. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and cash operating costs are expected to be constant over the project's 7-year life. What is the project's NPV? WACC12.0% Net capital investment in fixed assets$950,000 Required new working capital$30,000 Sales revenues, each year$580,000 Cash operating costs, each year$330,000 Expected pretax salvage value$50,000 Tax rate35.0%

Using the same discount rate to evaluate projects with differing degrees of risk would, over time, cause the firm to accept too many high-risk projects and to reject too many low-risk proposals.

After a project has been terminated, a firm cannot receive CCA deductions from it, and thus the CCA tax shield stops too.

You work for Athens Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow? Sales revenues$15,000 Capital cost allowance$4,000 Cash operating costs$6,000 Tax rate35.0%

Which of the following statements regarding CCA is true?

TexMex Products is considering a new salsa whose data are shown below. The equipment has a constant capital cost allowance over its 3-year life with a zero salvage value. No new working capital would be required. Revenues and cash 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 the company's pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3. Actual CCA varies. The proposed CCA is for computational convenience.) WACC10.0% Pre-tax cash flow reduction in other products (cannibalization)$5,000 Investment cost$65,000 Annual capital cost of allowance$21,665 Annual sales revenues$75,000 Annual cash operating costs$25,000 Tax rate35.0%

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's WACC. Which factor should the CFO include in the cash flows when estimating the relevant cash flows?

Zeta Software is considering a new project whose data are shown below. The required equipment has a 3-year project life, after which it will be worthless, and it has a constant deduction rate over 3 years. Revenues and cash operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow for Year 1? Equipment cost$75,000 Capital cost allowance$25,000 Sales revenues, each year$60,000 Cash operating costs$25,000 Tax rate35.0%

Moore & Moore (MM) is considering the purchase of a new machine for $50,000, installed. MM will use the CCA method to depreciate the machine. This machine is included in CCA class 8 (20%). MM expects to sell the machine at the end of its 4-year operating life for $10,000. If MM's marginal tax rate is 40%, what will be the present value of the CCA tax shield when it disposes of the machine at the end of Year 4? Assume that the relevant discount rate is 10%.

What will result from an increase in the risk-adjusted discount rate for a risky project?

Within the same asset class in the same year, when the sale of assets exceeds the purchase, net acquisition is negative. The half-year rule will apply.

Changes in net operating working capital do not need to be considered in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital.

The two cardinal rules that financial analysts follow to avoid capital budgeting errors are (1) capital budgeting decisions must be based on accounting income, and (2) all incremental cash flows should be considered when making accept/reject decisions.

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

If a firm's projects differ in risk, then different projects should be evaluated using risk-adjusted discount rates.

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

Which of the following statements is correct?

Superior analytical techniques, such as NPV, used in combination with cost of capital adjustments, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions.