Deck 11: Cash Flow Estimation and Risk Analysis

Question 1

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

Answer 1

True

Question 2

In capital budgeting terminology, an "externality" is defined as something that is outside, or external to, a proposed new project. Therefore, externalities are not considered in project cash flow estimates.

Answer 2

False

Question 3

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.

Answer 3

False

Question 4

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

Question 5

If an investment project would make use of land that the firm currently owns, the project should be charged with the opportunity cost of the land.

Question 6

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.

Question 7

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

Question 8

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.

Question 9

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 instead of a discounted cash flow analysis is recommended for such projects.

Question 10

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.

Question 11

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

Question 12

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.

Question 13

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.

Question 14

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 relevant in a capital budgeting analysis.

Question 15

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.

Question 16

The primary advantage of declining-balance depreciation over straight-line depreciation is that, while the total amount of depreciation and thus tax savings is unchanged, charges are taken sooner. This means that the firm gets the benefits of the tax savings sooner, which increases their present value.

Question 17

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.

Question 18

The undepreciated capital cost (UCC) is defined as the total cost of all assets in a class less the accumulated CCA for that class.

Question 19

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 estimating projects' cash flows.

Question 20

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.

Question 21

Which of the following statements best describes CCA?

A) Using CCA method rather than straight-line depreciation would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
B) Corporations must use the same depreciation method (e.g., straight-line or CCA) for stockholder reporting and tax purposes.
C) Since CCA deduction is not a cash expense, it has no affect on cash flows and thus no affect on capital budgeting decisions.
D) Under CCA rules, higher CCA deductions occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Question 22

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

A) changes in net operating working capital
B) shipping and installation costs
C) cannibalization effects
D) sunk costs that have been expensed for tax purposes

Question 23

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.

Question 24

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.

Question 25

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?

A) 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.
B) 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.
C) 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.
D) 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.

Question 26

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 of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

A) Project A, which has average risk and an IRR of 9%
B) Project B, which has below-average risk and an IRR of 8.5%
C) Project C, which has above-average risk and an IRR of 11%
D) Without information about the projects' NPVs we cannot determine which one(s) should be accepted

Question 27

Which of the following statements best describes CCA?

A) Since CCA deduction is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
B) When corporations use CCA depreciation method, the stockholder report financially looks better.
C) CCA is a pool concept calculating values for the entire asset class, not individual assets.
D) Using CCA declining-balance depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project's forecasted NPV.

Question 28

What is the best approach to take into account of the relative risk of a proposed project?

A) adjusting the discount rate upward if the project is judged to have above-average risk
B) reducing the NPV by 10% for risky projects
C) picking a risk factor equal to the average discount rate
D) ignoring risk because project risk cannot be measured accurately

Question 29

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

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 at the end of the project's life

Question 30

Which of the following statements best describes sunk costs?

A) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
B) A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
C) A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
D) Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

Question 31

Which of the following statements best describes externalities?

A) An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favourable effect on other operations, then this is not an externality.
B) An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.
C) The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favour the NPV.
D) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

Question 32

Which of the following statements best describes CCA?

A) Since CCA deduction is not a cash expense, it plays no role in capital budgeting.
B) The CCA method use a specific mandated CCA rate for each asset class.
C) The CCA deduction is equal to the year-end UCC for the pool divided by the mandated CCA rate.
D) The CCA method allows that the net capital cost of an asset is added to the pool in the year the asset is put in use.

Question 33

Which of the following statements best describes sunk costs?

A) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
B) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
C) A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed those funds for tax purposes, and now is deciding whether to go forward with the project.
D) If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.

Question 34

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

A) The new project is expected to reduce sales of one of the company's existing products by 5%.
B) Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost.
C) The company has spent and expensed $1 million on R&D associated with the new project.
D) The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

Question 35

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

Question 36

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.

Question 37

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 one of the following factors should the CFO include in the cash flows when estimating the relevant cash flows?

A) all interest expenses on debt used to help finance the project
B) 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
C) sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year
D) effects of the project on other divisions of the firm, but only if those effects lower the direct cash flows of the project

Question 38

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

A) all overhead costs incurred
B) interest on funds borrowed to help finance the project
C) the end-of-project recovery of any working capital required to operate the project
D) cannibalization effects, but only if those effects increase the project's projected cash flows

Question 39

Opportunity costs include those cash inflows that could be generated from assets the firm already owns, if those assets were not used for the project being evaluated.

Question 40

Which of the following statements is correct?

A) If a project can create employment in a slump area, firm should include such an externality in the NPV calculations.
B) If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.
C) If cannibalization is determined to exist, then this means that the calculated NPV considering cannibalization will be higher than the NPV that does not recognize these effects.
D) Cannibalization is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Question 41

Taussig Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following numbers: Which of the following statements is correct?

A) Project X has more stand-alone risk than Project Y.
B) Project X has more corporate (or within-firm) risk than Project Y.
C) Project X has more market risk than Project Y.
D) Project X has the same level of corporate risk as Project Y.

Question 42

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the company's average projects. 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?

A) The proposed new project would have more stand-alone risk than the firm's typical project.
B) The proposed new project would increase the firm's corporate 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.

Question 43

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?

A) $12,380
B) $13,032
C) $14,440
D) $15,200

Question 44

Which of the following statements is correct?

A) Straightforward sensitivity analysis, as it is generally employed, is incomplete in that it fails to consider the range of likely values for the key input variables and the probabilities of different input values.
B) A statistically based behavioural approach to project analysis that applies pre-determined probability distributions is the scenario approach.
C) A method for evaluating a project that uses a number of possible values for a given variable, such as cash inflows, to assess its impact on the firm's return is simulation analysis.
D) Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.

Question 45

Your company, Omega Corporation, is considering a new project that you must analyze. Based on the following data, what is the project's Year 1 operating cash flow?

A) $10,585
B) $10,913
C) $11,250
D) $11,588

Question 46

Which of the following statements is correct?

A) In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.
B) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
C) If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the new project were not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration.
D) If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

Question 47

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?

A) $29,196
B) $29,945
C) $30,712
D) $31,500

Question 48

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

A) The company will produce the detergent in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce other Laurier products.
B) The project will utilize some equipment the company currently owns but is not now using. A used-equipment dealer has offered to buy the equipment.
C) The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research is expected to benefit other projects that might be proposed in the future.
D) The new detergent will cut into sales of the firm's other detergents.

Question 49

Which of the following does NOT have incremental cash flow effects and thus should NOT be considered in capital budgeting decisions?

A) A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
B) A firm must obtain new equipment for the project, and $1 million of costs for shipping and installing the new machinery will be required.
C) A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered if the new project is rejected.
D) A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.

Question 50

Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Which set of projects would maximize shareholder wealth?

A) A, B, and C.
B) A, B, and D.
C) A, B, C, and D.
D) A, B, C, D, and E.

Question 51

You work for the Sing Oil Company, which is considering a new project whose data are shown below. What is the project's net operating cash flow for Year 1?

A) $21,185
B) $22,300
C) $24,586
D) $25,815

Question 52

A) Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
B) One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
C) Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

Question 53

An increase in the risk-adjusted discount rate for a risky project will result in which of the following?

A) no change to the NPV
B) an increase in the IRR
C) an increase in the NPV
D) a decrease in the NPV

Question 54

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

A) the land that would be used for the new project could be sold to another firm.
B) revenues from an existing product that would be lost as a result of customers switching to the new product.
C) shipping and installation costs associated with preparing a machine that would be used to produce the new product.
D) the cost of a marketing study that was completed last year related to the new product. This research led to the tentative decision to go ahead with the new product, and the cost of the research was expensed for tax purposes last year.

Question 55

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?

A) $16,213.00
B) $20,067.50
C) $22,497.50
D) $18,863.50

Question 56

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

A) The interest paid on funds borrowed to finance a project must be included in the project's estimated cash flows.
B) Only incremental cash flows are relevant when making accept/reject decisions.
C) 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.
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 will have no effect on the cash flows used in the analysis.

Question 57

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is correct?

A) 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 WACC. If interest were deducted when estimating cash flows, it would in effect be "double-counted."
B) Since depreciation is a noncash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
C) When estimating the project's operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flow effects of externalities since they are accounted for in the discounting process.
D) Capital budgeting decisions should be based on BEFORE-TAX cash flows.

Question 58

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?

A) Increase the estimated IRR 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 the project's higher-than- average risk.

Question 59

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?

A) $7,250
B) $7,431
C) $7,617
D) $7,807

Question 60

Fool Proof Software is considering a new project whose data are shown below. The equipment has an economic life of 3 years, and is in the CCA class 10 (30%). Revenues and cash operating costs are expected to be constant over the project's 3-year life. What is the net operating cash flow for Year 1?

A) $26,162.50
B) $28,770.00
C) $30,359.25
D) $25,275.50

Question 61

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.

A) $5,320
B) $5,600
C) $5,880
D) $6,174

Question 62

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.)

A) $28,499
B) $23,402
C) $19,417
D) $16,284

Question 63

Party Place is considering a new investment whose data are shown below. The equipment that would be used would have a constant annual capital cost allowance over the project's 3-year life and a zero salvage value. This project would require some additional working capital that 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 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3. CCA is modified to smooth out the calculations.)

A) $24,112
B) $25,318
C) $26,584
D) $27,913

Question 64

Dumpe Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price will increase with inflation. Fixed costs will also be constant, but variable costs will rise with inflation. The project should last for 3 years, and there will be no salvage value. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV? (Note: the constant annual capital cost deduction rate facilitates the calculations.)

A) $8,536
B) $8,985
C) $9,458
D) $9,931

Question 65

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%.

A) $10,905
B) $9,059
C) $9,400
D) $8,930

Question 66

Easy Payment Loan Company is thinking of opening a new office, and the key data are shown below. Easy Payment owns the building, free and clear, and it would sell it for $100,000 after taxes if the company decides not to open the new office. The equipment that would be used would be depreciated by the straight-line method over the project's 3-year life, and would have a zero salvage value. An extra $5,000 of new working capital would be required to get this project running. Revenues and cash operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3 and the increased working capital will be recovered when this project ends. A simplified CCA is for mathematical convenience.)

A) $47,940
B) $50,464
C) $54,672
D) $55,915

Question 67

Merritt Company is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. Merritt could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, Merritt would have to make a payment to those parties. How much is the option to abandon worth (in thousands) to Merritt? WACC
=
11)5% Dollars in Thousands NPV this Prob ×
T = 0 t = 1 t = 2 t = 3 State NPV
Prob = 25% $800.0 $800.0 $800.0 $938.1 $234.5
Prob = 50% -$1,000 $520.0 $520.0 $520.0 $259.8 $129.9
Prob = 25% -$200.0 -$200.0 -$200.0 -$1,484.5 -$371.1
Exp) NPV= -$6.7

A) $68.8
B) $72.5
C) $76.3
D) $80.1

Question 68

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.)

A) $25,269
B) $26,599
C) $27,929
D) $29,325

Question 69

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?

A) $13,965
B) $15,226
C) $16,910
D) $17,882