Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  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. 
B)  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. 
C)  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. 
D)  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. 
E)  Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.

Question 2

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

Accepted Answer

A) True 
 B)False

Question 3

Which of the following statements is CORRECT?

Accepted Answer

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 favorable 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 favor 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. 
E)  Identifying an externality can never lead to an increase in the calculated NPV.

Question 4

Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives.

Accepted Answer

A) True 
 B)False

Question 5

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.

Accepted Answer

A) True 
 B)False

Question 6

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

Accepted Answer

A)  $8,903 
B)  $9,179 
C)  $9,463 
D)  $9,746 
E)  $10,039

Question 7

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 8

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

Accepted Answer

A)  The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. 
B)  Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. 
C)  Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. 
D)  Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. 
E)  DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.

Question 9

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

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

Question 11

A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

Accepted Answer

A) True 
 B)False

Question 12

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.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  Using accelerated depreciation rather than straight line 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)  Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. 
C)  Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. 
D)  Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. 
E)  Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)  Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. 
B)  Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. 
C)  If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. 
D)  If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. 
E)  If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Question 15

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

Accepted Answer

A)  All costs associated with the project that have been incurred prior to the time the analysis is being conducted. 
B)  Interest on funds borrowed to help finance the project. 
C)  The end-of-project recoof any working capital required to operate the project. 
D)  Cannibalization effects, but only if those effects increase the project's projected cash flows. 
E)  Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

Question 16

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 17

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

Accepted Answer

A)  The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows. 
B)  Only incremental cash flows, which are the cash flows that would result if a project is accepted, 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)  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. 
E)  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.

Question 18

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

Accepted Answer

A) True 
 B)False

Question 19

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 20

Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.

Accepted Answer

A) True 
 B)False

Exam 12: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

Which of the following statements is CORRECT?

Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives.

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.

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

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.

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

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

A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

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?

Which of the following statements is CORRECT?

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

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.

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

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

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

Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.