Finan 450 - Exam 4

- the project is a good investment - the cash flow estimations are inaccurate - overly optimistic management

A manager has estimated a positive NPV for a project. What could drive this result?

cannot be observed

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:

accepted

A project should be __________ if its NPV is greater than zero.

independent

A(n) ______ project does not rely on the acceptance or rejection of another project.

acceptable

Based on the average accounting return rule, a project is _____ if its average accounting return exceeds a target average accounting return.

the necessary financing

Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:

mutually exclusive

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 _______________.

100% reversed

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

required return

If the IRR is greater than the _______ ________, we should accept the project.

equal to zero when the discount rate equals the IRR negative for discount rates above the IRR positive for discount rates below the IRR

In general, NPV is ___.

required return

Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.

- Inventory is purchased -Credit sales are made -Cash is kept for unexpected expenditures

Investment in net working capital arises when ___.

beneficial spillover effects erosion effects

Side effects from investing in a project refer to cash flows from:

payment

The ______ method evaluates a project by determining the time needed to recoup the initial investment.

incremental

The stand-alone principle assumes that evaluation of a project may be based on the project's ________________ cash flows.

true

True or false: Investment in net working capital may arise from the need to cover credit sales.

true

True or false: Net working capital will be recovered at the end of a project.

false--operating cash flow = EBIT + depreciation - taxes

True or false: Operating cash flow is based on the salvage value of equipment.

true--whenever subsequent cash flows are both negative and positive, multiple internal rates of return may occur

True or false: Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.

false--you need the discount rate to calculate the NPV but it is not required for the IRR calculation

True or false: The IRR is easy to use because you only need to know the appropriate discount rate.

false

True or false: The depreciation tax shield is the depreciation deduction divided by the tax rate.

1. operating cash flow 2. capital spending 3. change in net working capital

Which of the following are components of project cash flow?

OCF = (Sales - Costs) x (1-Tax rate) + Depreciation x Tax rate

Which of the following is the equation for estimating operating cash flows using the tax shield approach?

NPV

Which of the following techniques will provide the most consistently correct result?

spreadsheet function for calculating NPV

=NPV(rate,CF1,...,CFn) + CF0

stand-alone

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

payback period NPV IRR

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

arbitrary

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

increase

Synergy will _____ the sales of existing products.

trye

T/F: 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.

accepts

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

true

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: The measure of average accounting profit is in the numerator of the average accounting return (AAR) formula.

false

True or false: The payback period takes into consideration the time value of money.

Cannot rank mutually exclusive projects

Which of the following is a disadvantage of the Profitability Index?

opportunity costs

benefits lost due to taking on a particular project

sunk costs

costs that have already occurred and are not affected by accepting or rejecting a project

NWC

current assets - current liabilites = what

The Average Accounting Return (AAR) Rule states that a company will accept a project that has an average account return that:

exceeds a pre-determined target average accounting return.

depreciation tax shield

the tax savings that results from the depreciation deduction.

rent on a production facility cost of equipment

what are two fixed costs

reduce

Erosion will ______ the sales of existing products.

unit sales variable costs selling price per unit

Estimates of which of the following are needed to prepare pro forma income statements?

a target average accounting return

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

reject a project if the IRR is less than the required return

According to the basic IRR rule, we should:

Net Working Capital (NWC)

Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.

The operating cash flows from net sales over the life of the project

Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?

net cash flows from sales and expenses over the life of a project. net cash flows from salvage value at the end of the project. cash outflows from investment in plant and equipment at the inception of the project.

Identify the three main sources of cash flows over the life of a typical project.

ignored--in order to separate the investment from the financing of that investment, you must ignore any costs associated with financing. cash flows from the project should be completed without taking into account the costs associated with the financing of the project.

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

How long it takes to recover the initial investment

What is the primary concern of the payback period rule?

-Hard rationing implies the firm is unable to raise funds for projects-Soft Rationing is typically internal in that the firm allocates funds to divisions for capital projects.

Which of the following is true relative to capital rationing?

non-conventional cash flows mutually exclusive projects

Which of the following present problems when using the IRR method?

relevant--while determining the operating cash flows is important, it is not the most important step

One of the most important steps in estimating cash flow is to determine the _________ cash flows.

EBIT, taxes, depreciation

Operating cash flow is a function of:

relevant

Opportunity costs are classified as ____ costs in project analysis.

payback period; NPV

The __________ is best suited for decisions on relatively small, minor projects while ______ is more appropriate for large complex projects.

-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.

The basic NPV investment rule is:

incremental cash flows

The difference between a firm's cash flows with a project versus without the project is called ________________.

net working capital

The difference between a firm's current assets and its current liabilities is known as the _____.

more

The discounted cash flow valuation shows that higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on.

a project's cash flows

The internal rate of return is a function of ____.

opportunity cost

The most valuable alternative that is given up if an investment is undertaken is called what?

zero

The multiple rates of return problem is the possibility that more than one discount rate may make the net present value of an investment equal to .

it ignores cash flows after the cutoff date

The payback period can lead to foolish decisions if it is used too literally because:

initial cost

The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its _____ _____.

future

The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.

minus

The project cash flow equals the project operating cash flow ___ project change in NWC minus project capital spending.

-it determines taxes owed on fixed assets when they are sold-it determined the book value of assets which affects net salvage value-it affects a firms annual tax liability

Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:

true--an IRR will result for every change in sign in the cash flow stream

True or false: A project with non-conventional cash flows will produce two or more IRRs.

true

True or false: When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the discount rate raised to the nth power.

project consultation fee

Which of the following is an example of a sunk cost? Project variable cost Project consultation fee Bonus to top management based on project success Salvage value of equipment

Rent income likely to be lost by using a vacant building for an upcoming project

Which of the following is an example of an opportunity cost?

after-tax

Cash flows should always be considered on a(n) ___________ basis.

after-tax cash flows cash flows when they occur

Cash flows used in project estimation should always reflect:

recovered

Given a level of investment in net working capital, that same investment must be ___ at some time in the future.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

direct

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.

-The discount rate in Excel is entered is decimal, or as a percentage with a percent sign. -The range of cash flows specified in Excel begins with cashflow #1, not cashflow 0. -With the Excel NPV function, Cashflow #0 must be handled outside the NPV function. -The Excel NPV function is actually a PV function.

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?

average net income/average book value

The Average Accounting Return is defined as:

accept--if the PI is greater than 1, the present value of the cash flows generated by a project exceed the project's initial cost

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

cost-benefit

The Profitability Index is also called the __________ ratio.

relevant cash flows

The first step in estimating cash flow is to determine the _________ cash flows.

1986 Tax Reform Act

The rules for depreciating assets for tax purposes are based upon provisions in the:

false

True or false: An advantage of the AAR is that it is based on book values, not market values.

false--the PI may lead to incorrect decisions in comparisons of mutually exclusive investments

True or false: The PI always results in the correct decision in comparisons of mutually exclusive investments.

false

True or false: The discounted cash flow (DCF) valuation estimates future value as the difference between the market price and the cost of the investment.

false--the profitability index rule for an independent project states that, if a projectt has a positive NPV, then the present value of the future cash flows must be smaller than the initial investment.

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.

the tax shield approach

What approach does the following formula describe? OCF = (Sales - Costs) x (1-TC) + Depreciation x TC

1. the payback period method is easy to use 2. it allows lower level managers to make small decisions effectively 3. the payback period method is ideal for short projects

What are the advantages of the payback period method for management?

Requires an arbitrary cutoff point

Which of the following is a disadvantage of the payback period rule?

market value

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?

false

True or false: Fixed costs cannot be changed over the life of the investment.

false--fixed costs cannot be changed in the short term but can be changed over the long term

True or false: Fixed costs cannot be changed over the life of the investment.

false--in analyzing a proposed investment, you should not include interest paid or any other financing costs.

True or false: In calculating cash flows, you should consider all financing costs.

Cash flows from erosion effects Cash flows from beneficial spillover effects Cash flows from external costs

Which of the following are considered relevant cash flows?

1. it considers the riskiness of the project. 2. it considers time value of money. 3. it considers all the cash flows. 4. it properly chooses among mutually exclusive projects (helps rank).

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

Net Present Value

__ is a measure of how much value is created or added by undertaking an investment.