FIN 3403 Exam 5
What are the two main drawbacks of sensitivity analysis?
It does not consider interaction among variables It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.
In the context of capital budgeting, what does sensitivity analysis do?
It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.
What are the two main benefits of performing sensitivity analysis?
It identifies the variable that has the most effect on NPV. It reduces a false sense of security by giving a range of values for NPV instead of a single value.
What is an important drawback of traditional NPV analysis?
It ignores managerial options in investment decisions.
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
It properly chooses among mutually exclusive projects It considers time value of money. It considers all the cash flows. It considers the riskiness of the project.
The profitability index is calculated by dividing the PV of the ______ cash inflows by the initial investment.
future
Sunk costs are costs that
have already occurred and are not affected by accepting or rejecting a project
The basic NPV investment rule is:
if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. accept a project if the NPV is greater than zero. reject a project if its NPV is less than zero.
Interest expenses incurred on debt financing are ______ when computing cash flows from a project.
ignored
The stand-alone principle assumes that evaluation of a project may be based on the project's ______ cash flows.
incremental
In general, NPV is
negative for discount rates above the IRR positive for discount rates below the IRR equal to zero when the discount rate equals the IRR
When using ______, all of the variables except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable.
sensitivity analysis
According to the ______ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."
stand-alone
Options for future, related business products or strategies are called _____options
strategic
True or false: While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time.
true
In a competitive market, positive NPV projects are
uncommon
In order to analyze the risk of a project's NPV estimate, we should establish _____ for each important estimate variable.
upper and lower bounds
Estimates of which of the following are needed to prepare pro forma income statements?
variable costs unit sales selling price per unit
The basic approach to evaluating cash flow and NPV estimates involves asking
what-if questions
Soft rationing is a type of capital rationing that occurs
when units in a business are allocated a certain amount of financing for capital budgeting
The IRR is the discount rate that makes NPV equal to
zero
Broadband, Inc., has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of ______ as the base case.
$400,000
Though depreciation is a noncash expense, it is important to capital budgeting for these reasons:
it determines taxes owed on fixed assets when they are sold it determines the book value of assets which affects net salvage value it affects a firm's annual tax liability
Which of the following is the equation for estimating operating cash flows using the tax-shield approach?
OCF = (Sales - Costs) × (1 − Tax rate) + Depreciation × Tax rate
What is the difference between scenario analysis and sensitivity analysis?
Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time.
Scenario analysis considers a combination of factors for each scenario, while _____ analysis focuses on only one variable at a time.
Sensitivity
Which of the following are reasons why IRR continues to be used in practice?
The IRR of a proposal can be calculated without knowing the appropriate discount rate. It is easier to communicate information about a proposal with an IRR. Businesspeople prefer to talk about rates of return.
A manager has estimated a positive NPV for a project. What could drive this result?
The cash flow estimations are inaccurate. The project is a good investment. Management rationality could drive this result.
Which of the following are weaknesses of the payback method?
The cutoff date is arbitrary. Cash flows received after the payback period are ignored. Time value of money principles is ignored.
Which of the following qualify as "managerial options"?
The option to wait The option to expand The option to abandon
The primary risk in estimation errors is the potential to
make incorrect capital budgeting decisions
The project cash flow equals the project operating cash flow _______ project change in NWC minus project capital spending.
minus
Specifying variables in the Excel NPV function differs from the manner in which they are entered in a financial calculator in which of the following ways?
The range of cash flows specified in Excel begins with Cashflow 1, not Cashflow 0. The discount rate in Excel is entered as a decimal, or as a percentage with a percent sign. With the Excel NPV function, Cashflow 0 must be handled outside the NPV function. The Excel NPV function is actually a PV function.
The profitability index (PI) rule for an independent project is to ______ the project if the PI is greater than 1.
accept
Based on the average accounting return rule, a project is ______ if its average accounting return exceeds a target average accounting return.
acceptable
The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.
accepts
Cash flows should always be considered on a(n) _____ basis
aftertax
Cash flows used in project estimation should always reflect:
aftertax cash flows. cash flows when they occur.
When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in
asking what-if questions scenario analysis
The goals of risk analysis in capital budgeting include
assessing the degree of forecasting risk identifying critical components
The profitability index is also called the ______ ratio.
benefit-cost
Opportunity costs are
benefits lost due to taking on a particular project
A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:
cannot be observed.
Which of the following are considered relevant cash flows?
cash flows from external costs cash flows from beneficial spillover effects cash flows from erosion effects
Managerial options are taken into consideration in ____ planning
contingency
Investment in net working capital arises when
credit sales are made inventory is purchased cash is kept for unexpected expenditures
What is scenario analysis?
determines the impact on NPV of a set of events relating to a specific scenario.
Incremental cash flows come about as a(n) ______ consequence of taking a project under consideration.
direct
Side effects from investing in a project refer to cash flows from:
erosion effects. beneficial spillover effects.
The possibility that errors in projected cash flows will lead to incorrect decisions is known as
estimation risk forecasting risk
True or false: An advantage of the AAR is that it is based on book values, not market values.
false
True or false: In calculating cash flows, you should consider all financing costs.
false
True or false: Operating cash flow is based on the salvage value of equipment.
false
True or false: Sensitivity analysis is helpful because it indicates what we should do regarding forecasting errors.
false
True or false: The IRR is easy to use because you only need to know the appropriate discount rate.
false
True or false: The payback period takes into consideration the time value of money.
false
True or false: The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its future cost.
false
True or false: The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be smaller than the initial investment.
false
True or false: The value of managerial options is taken into account when performing conventional NPV analysis.
false
An increase in depreciation expense will ______ cash flows from operations.
increase
The difference between a firm's cash flows with a project versus without the project is called
incremental cash flows
A(n) ______ project does not rely on the acceptance or rejection of another project. Multiple choice question.
independent
The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its
initial cost
If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered
mutually exclusive
Which of the following techniques will provide the most consistently correct result?
net present value
According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), which of the following two capital budgeting methods are widely used by firms in the United States and Canada?
net present value internal rate of return
Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in
net working capital
Which of the following present problems when using the IRR method?
nonconventional cash flows mutually exclusive projects
Which of the following are components of project cash flow?
operating cash flow change in net working capital capital spending
The _____ method evaluates a project by determining the time needed to recoup the initial investment.
payback
The ______ is best suited for decisions on relatively small, minor projects, while ______ is more appropriate for large, complex projects.
payback period; NPV
Which of the following is an example of a sunk cost?
project consultation fee
An option on a real asset rather than a financial asset is known as a
real option managerial option
One of the most important steps in estimating cash flow is to determine the ____ cash flows.
relevant
Opportunity costs are classified as ______ costs in project analysis.
relevant
The first step in estimating cash flow is to determine the ______ cash flows.
relevant
Internal rate of return (IRR) must be compared to the ______ in order to determine the acceptability of a project.
required return
Which of the following is a disadvantage of the payback period rule?
requires an arbitrary cutoff point
______ analysis is useful in pinpointing variables that deserve the most attention.
sensitivity
Operating cash flow is a function of _________.
taxes depreciation earnings before interest and taxes
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus Blank______ rate raised to the nth power.
the discount
Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find
the necessary financing
Which option should be chosen if a project does not break even on a cash flow basis?
the option to abandon
Which of the following are methods of calculating the MIRR of a project?
the reinvestment approach the combination approach the discounting approach
What approach does the following formula describe? OCF = (Sales − Costs) × (1 − TC) + Depreciation × TC
the tax-shield approach
True or false: A disadvantage of the AAR is that it does not take into account the time value of money.
true
True or false: A project with nonconventional cash flows will produce two or more IRRs.
true
True or false: Investment in net working capital may arise from the need to cover credit sales.
true
True or false: To prepare proforma financial statements, estimates of quantities such as unit sales, selling price per unit, variable cost per unit, and total fixed costs are required.
true
If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be:
100 percent reversed.
The spreadsheet function for calculating net present value is
=NPV(rate,CF1, ..., CFn) + CF0
Which of the following correctly describes the relationship between depreciation, income, taxes, and investment cash flows?
As depreciation expense increases, net income and taxes will decrease, while investment cash flows will increase.
A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish?
Market value
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
NPV IRR payback period
True or false: The number of positive NPV projects is unlimited for any given firm.
False
What are the advantages of the payback period method for management?
It allows lower-level managers to make small decisions effectively. The payback period method is easy to use. The payback period method is ideal for minor projects.
The internal rate of return is a function of
a project's cash flows
The combination MIRR method is used by the Excel MIRR function and uses which of the following?
a reinvestment rate for compounding compounding cash inflows to the end of the project a financing rate for discounting discounting all cash outflows to time 0
According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:
a target average accounting return
