TEST BANK CHAPTER 12 CASH FLOW ESTIMATION AND RISK ANALYSIS QUẢN TRỊ TÀI CHÍNH

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

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

TOPICS: Cash flow estimation

KEYWORDS: Bloom’s: Knowledge

2 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

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

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4 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

TOPICS: Relevant cash flows

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

FOFM.BRIG.16.12.01 - Conceptual Issues in Cash Flow Estimation

Cengage Learning Testing, Powered by Cognero Page 2

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6 If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis

KEYWORDS: Bloom's: Comprehension

7 Any cash flows that can be classified as incremental to a particular project—i.e., results directly from the decision to undertake the project—should be reflected in the capital budgeting analysis

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8 We can identify the cash costs and cash inflows to a company that will result from a project These could be called

"direct inflows and outflows," and the net difference is the direct net cash flow If there are other costs and benefits that donot flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part ofthe capital budgeting analysis

United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking

STATE STANDARDS: United States - OH - DISC.FOFM.BRIG.16.03 - Capital budgeting and

cost of capital

9 In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects

on the firm's long-run cash flows

cost of capital

10 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

a True

b Fals

e

RATIONALE: If the externality is potentially important, it should not be ignored, because then a

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large error might be made At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of its possible effects.

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

cost of capital

12 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

FOFM.BRIG.16.12.02 - Analysis of an Expansion Project

NATIONAL ST United States - BUSPROG.FOFM.BRIG.16.06 - Reflective thinking

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TOPICS: Depreciation cash flows

13 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

14 Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant

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15 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

16 Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus

increasing their present value On the other hand, using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes

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

a True

b Fals

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cost of capital

18 Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions for capital budgeting projects

19 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 is often used for such projects along with discounted cash flow analysis

12-1 Conceptual Issues in Cash Flow Estimation

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United States - OH - DISC.FOFM.BRIG.16.01 - Stocks and bonds

20 The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numeratorshould use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects

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

cost of capital

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KEYWORDS: Bloom’s: Knowledge

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

cost of capital

23 The change in net operating working capital associated with new projects is always positive, because new projects mean that more operating working capital will be required

cost of capital

24 The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant

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25 Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected

by a small change in one of the input variables, say sales Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant

cost of capital

26 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

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cost of capital

27 Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because not projects meet the assumptions the method requires

cost of capital

28 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 beyond their initial lives

cost of capital

29 The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the equivalent annual annuity (EAA) approach

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cost of capital

30 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

cost of capital

31 Which of the following is NOT a relevant 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 for machinery

FOFM.BRIG.16.12.01 - Conceptual Issues in Cash Flow Estimation

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TOPICS: Cash flow issues

32 The relative risk of a proposed project is best accounted for by which of the following procedures?

a Adjusting the discount rate upward if the project is judged to have above-average risk

b Adjusting the discount rate upward if the project is judged to have below-average

risk

c Reducing the NPV by 10% for risky projects

d Picking a risk factor equal to the average discount rate

e Ignoring risk because project risk cannot be measured accurately

United States - BUSPROG.FOFM.BRIG.16.03 - Analytic skills

cost of capital

33 Suppose Tapley Inc 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 = 9%

b Project B, which has below-average risk and an IRR = 8.5%

c Project C, which has above-average risk and an IRR = 11%

d Without information about the projects' NPVs we cannot determine which one or ones

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cost of capital

34 Which of the following statements is CORRECT?

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 project's NPV

e A good example of a sunk cost is a situation where Home Depot opens a new store,

and that leads to a decline in sales of one of the firm's existing stores

cost of capital

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 a situation where a bank opens a new office, and that

new office leads to a decline in deposits of the bank's other offices

d.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 that cost for tax purposes, and now

is deciding whether to go forward with the project

e 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 have been had the sunk costs

been ignored

REFERENCES: 12-1 Conceptual Issues in Cash Flow Estimation

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cost of capital

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

cost of capital

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 increase

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

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e Identifying an externality can never lead to an increase in the calculated NPV.

cost of capital

a If a firm is found guilty of cannibalization in a court of law, then it is judged to have

taken unfair advantage of its competitors Thus, cannibalization is dealt with by

society through the antitrust laws

b.If a firm is found guilty of cannibalization in a court of law, then it is judged to have

taken unfair advantage of its customers Thus, cannibalization is dealt with by society

through the antitrust laws

c 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

d.If cannibalization is determined to exist, then this means that the calculated NPV if

cannibalization is considered will be higher than the NPV if this effect is not

recognized

e Cannibalization, as described in the text, is a type of externality that is not against the

law, and any harm it causes is done to the firm itself

cost of capital

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

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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

cost of capital

a Since depreciation is a cash expense, the faster an asset is depreciated, the lower the

projected NPV from investing in the asset

c Corporations must use the same depreciation method for both stockholder reporting

and tax purposes

d.Using accelerated depreciation rather than straight line normally has the effect of

speeding up cash flows and thus increasing a project's forecasted NPV

e Using accelerated depreciation rather than straight line normally has the effect of

slowing down cash flows and thus reducing a project's forecasted NPV

cost of capital

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OTHER: Multiple Choice: Conceptual

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

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

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

higher than they would be if straight-line depreciation were required for tax purposes

cost of capital

42 Other things held constant, which of the following would increase the NPV of a project being considered?

a A shift from straight-line to MACRS depreciation

b Making the initial investment in the first year rather than spreading it over the first

three years

c An increase in the discount rate associated with the project

d An increase in required net operating working capital

e The project would decrease sales of another product line

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cost of capital

43 A company is considering a new project The CFO plans to calculate the project's NPV by estimating the relevant cashflows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), 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?

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 additional investment in net operating 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

KEYWORDS: Bloom's: Analysis

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

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 recovery of any additional net operating 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

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

a Changes in net operating 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

46 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 of the capital

budgeting analysis 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

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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

e 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

KEYWORDS: Bloom's: Application

47 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 research and development costs

associated with the new project

d.The company spent and expensed $10 million on a marketing study before its current

analysis regarding whether to accept or reject the project

e 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

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48 Dalrymple Inc is considering production of a new product 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 new product 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 another of the firm's 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 product These funds cannot be recovered, but the research may benefit

other projects that might be proposed in the future

d.The new product will cut into sales of some of the firm's other products

e If the project is accepted, the company must invest an additional $2 million in net

operating working capital However, all of these funds will be recovered at the end of

the project's life

KEYWORDS: Bloom's: Evaluation

49 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 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 for capital budgeting

projects

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

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is complementary to some of the firm's other products, this fact need not be reflected

a In a capital budgeting analysis where part of the funds used to finance the project

would be 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.In a capital budgeting analysis where part of the funds used to finance the project

would be raised as debt, failure to include interest expense as a cost when determining

the project's cash flows will lead to a downward bias in the NPV

c The existence of any type of "externality" will reduce the calculated NPV versus the

NPV that would exist without the externality

d.If one of the assets to be used by a potential project is already owned by the firm, and

if that asset could be sold or leased to another firm if the new project were not

undertaken, then the net proceeds that could be obtained should be charged as a cost to

the project under consideration

e 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

RATIONALE: Regarding a and b, note that since interest should not be considered, exclusion

will not lead to any type of bias, positive or negative

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51 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?

a A firm has a parcel of land that can be used for a new plant site or be sold, rented, or

used for agricultural purposes

b.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

c A firm must obtain new equipment for the project, and $1 million is required for

shipping and installing the new machinery

d.A firm has spent $2 million on research and development associated with a new

product These costs have been expensed for tax purposes, and they cannot be

recovered regardless of whether the new project is accepted or rejected

e A firm can produce a new product, and the existence of that product will stimulate

sales of some of the firm's other products

TOPICS: Incremental cash flows

52 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?

a 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

b.Revenues from an existing product would be lost as a result of customers switching to

the new product

c Shipping and installation costs associated with a machine that would be used to

produce the new product

d.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

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e 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

TOPICS: Incremental cash flows

53 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, this

would, in effect, "double count" it

b.Since depreciation is a non-cash 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 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

d.Capital budgeting decisions should be based on before-tax cash flows because WACC

is calculated on a before-tax basis

e The WACC used to discount cash flows in a capital budgeting analysis should be

calculated on a before-tax basis To do otherwise would bias the NPV upward

TOPICS: New project cash flows

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