FIN Ch. 9
We underestimate NPV because of the option(s) to ______.
expand abandon
True or false: The depreciation tax shield is the depreciation deduction divided by the tax rate.
False
True or false: The value of managerial options is taken into account when performing conventional NPV analysis.
False
The Market Farms purchased a parcel of land six years ago for $200,000. At that time, the firm invested $75,000 grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $40,000 a year. The Market Farms is now considering building a hotel on the site as the rental lease is expiring. The current value of the land is $225,000. The firm has no loans or mortgages secured by the property. What value should be included in the initial cost of the hotel project for the use of this land?
$225,000
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
Classic Cars is considering a project that requires $311,250 of fixed assets that are classified as five-year property for MACRS. What is the book value of these assets at the end of Year 3? The MACRS allowance percentages are as follows, commencing with Year 1: 20.00, 32.00, 19.20, 11.52, 11.52, and 5.76 percent.
$89,640
If a firm's sales estimate used in its base case analysis is 1,000 units per year and they anticipate the upper and lower bounds to be +/- 15%, What is the "best case" for units sold per year?
1,150
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% reversed.
The rules for depreciating assets for tax purposes are based upon provisions in the:
1986 Tax Reform Act
A five-year project is expected to generate annual revenues of $159,000, variable costs of $72,500, and fixed costs of $15,000. The annual depreciation is $19,500 and the tax rate is 21 percent. What is the annual operating cash flow?
60,580
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.
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
Which of the following is an example of an opportunity cost?
Rental income likely to be lost by using a vacant building for an upcoming project
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.
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?
The operating cash flows from net sales over the life of the project
Which of the following qualify as "managerial options"?
The option to wait The option to expand The option to abandon
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
Cash flows used in project estimation should always reflect:
after-tax 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
Which of the following are fixed costs?
cost of equipment rent on a production facility
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:
forecasting risk estimation risk
Sunk costs are costs that ____.
have already occurred and are not affected by accepting or rejecting a project
If we find that our estimated NPV is sensitive to a variable that is difficult to forecast, then the degree of forecasting risk is _____.
high
Interest expenses incurred on debt financing are ______ when computing cash flows from a project.
ignored
An increase in depreciation expense will ____ cash flows from operations.
increase
Synergy will _____ the sales of existing products.
increase
The stand-alone principle assumes that evaluation of a project may be based on the project's ________________ cash flows.
incremental
The difference between a firm's cash flows with a project versus without the project is called ________________.
incremental cash flows
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
Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.
net working capital
The difference between a firm's current assets and its current liabilities is known as the _____.
net working capital
Ed owns a store that caters primarily to men. Each of the answer options represents an item related to a planned store expansion. Each of these items should be included in the expansion analysis with the exception of the cost:
of the blueprints that have been drawn of the expansion area
The most valuable alternative that is given up if an investment is undertaken is called what?
opportunity cost
The first step in estimating cash flow is to determine the _________ cash flows.
relevant
West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.
reliability
Estimates of which of the following are needed to prepare pro forma income statements?
selling price per unit variable costs unit sales
Scenario analysis considers a combination of factors for each scenario while _____ analysis focuses on only one variable at a time.
sensitivity
To investigate the impact on NPV of a change in one variable, you would employ ________.
sensitivity analysis
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
The depreciation tax ____ is the tax savings that results from the depreciation deduction.
shield
Which of the following is true relative to capital rationing?
soft rationing is typically internal in that the firm allocates funds to divisions for capital projects hard rationing implies the firm is unable to raise funds for projects
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
The Shoe Box is considering adding a new line of winter footwear to its product lineup. When analyzing the viability of this addition, the company should include all of the following in its analysis with the exception of:
the research and development costs to produce the current winter footwear samples.
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
The basic approach to evaluating cash flow and NPV estimates involves asking:
what-if questions
What is net working capital?
Current assets minus current liabilities
If a firm's variable cost per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper and lower bounds to be +/- 10%, What is the "worst case" for variable cost per unit?
$55
Left Eye Promotions is a specialty retailer offering T-shirts, sweatshirts, and caps. Its most recent annual sales consisted of $27,000 of T-shirts, $21,000 of sweatshirts, and $3,500 of caps. The company is adding polo shirts to the lineup and projects that this addition will result in sales next year of $25,000 of T-shirts, $17,000 of sweatshirts, $14,000 of Polo shirts, and $3,000 of caps. What sales amount should be used when evaluating the Polo shirt project?
$7,500 (25000+17000+14000+3000)-(27000+21000+3500)
An asset used in a three-year project falls in the three-year MACRS class for tax purposes. The MACRS percentage rates starting with Year 1 are: 33.33, 44.45, 14.81, and 7.41.The asset has an acquisition cost of $2.6 million and will be sold for $1.1 million at the end of the project. If the tax rate is 34 percent, what is the aftertax salvage value of the asset?
$791,504.40 2600000 x (0.3333+0.4445+0.1481) = 2407340 2600000-2407340 = 192660 1100000-192660 = 907340 907340 x 0.34 = 308496 1100000-308495.6 = 791504
Sandy Bottom, Inc., purchased some seven-year MACRS welding equipment six years ago at a cost of $60,000. Today, the company is selling this equipment for $10,000. The tax rate is 21 percent. What is the aftertax cash flow from this sale? The MACRS allowance percentages are as follows, commencing with Year 1: 14.29, 24.49, 17.49, 12.49, 8.93, 8.92, 8.93, and 4.46 percent.
11,824.41 0.1429+0.2449+0.1749+0.1249+0+ 0.6876 0.6876 x 60000 = 41256 60000-41256= 18744 10000-18744 = -8744 -8744 x 0.21 = -1836.24 -1836.24-10000 = -11836.2
The Corner Shop is considering a new four-year expansion project that requires an initial fixed asset investment of $210,000. The fixed asset will be depreciated straight-line to zero over its four-year life, after which time it will be worthless. The project is estimated to generate $48,000 in annual sales, with costs of $31,000. If the tax rate is 34 percent, what is the OCF for this project?
29,070
A cost-cutting project will decrease costs by $52,000 a year. The annual depreciation on the project's fixed assets will be $5,000 and the tax rate is 21 percent. What is the amount of the change in the firm's operating cash flow resulting from this project?
42,130 52000-5000=47000 47000 x 0.21 =9870 47000-9870 = 37130 37130 + 5000 =
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.
Which of the following are considered relevant cash flows?
Cash flows from beneficial spillover effects Cash flows from external costs Cash flows from erosion effects
True or false: Taxes are based on the difference between the initial cost and the sales price.
False
Which of the following are components of project cash flow?
Change in net working capital Capital spending Operating cash flow
The number of positive NPV projects is unlimited for any given firm.
False
True or false: Fixed costs cannot be changed over the life of the investment.
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
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.
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
It properly chooses among mutually exclusive projects It considers all the cash flows. It considers time value of money. It considers the riskiness of the project.
Which of the following techniques will provide the most consistently correct result?
Net Present Value
Identify the three main sources of cash flows over the life of a typical project.
Net cash flows from salvage value at the end of the project Net cash flows from sales and expenses over the life of the project Cash outflows from investment in plant and equipment at the inception of the project
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
Which of the following is an example of a sunk cost?
Project consultation fee
What is scenario analysis?
Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.
______ analysis is useful in pinpointing variables that deserve the most attention.
Sensitivity
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
Taxes are based on the difference between the book value and the sales price. There will be a tax savings if the book value exceeds the sales price. Book value represents the purchase price minus the accumulated depreciation.
Operating cash flow is a function of:
Taxes, Earnings Before Interest and Taxes (EBIT), Depreciation
What approach does the following formula describe? OCF = (Sales - Costs) x (1-TC) + Depreciation x TC
The Tax Shield Approach
A manager has estimated a positive NPV for a project. What could drive this result?
The cash flow estimations are inaccurate. Overly optimistic management The project is a good investment.
True or false: If analysts are overly optimistic about the future, then they may accept a project that realistically has a negative NPV.
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.
True
True or false: While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time.
True
Cash flows should always be considered on a(n) ___________ basis.
after-tax
The goals of risk analysis in capital budgeting include:
assessing the degree of financing risk identifying critical components
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
Managerial options are taken into consideration in ____ planning.
contingency
Managerial options are taken into consideration in _____ planning.
contingency
Investment in net working capital arises when ___.
inventory is purchased credit sales are made cash is kept for unexpected expenditures
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:
it affects a firm's annual tax liability it determines the book value of assets which affects net salvage value it determines taxes owed on fixed assets when they are sold
An option on a real asset rather than a financial asset is known as a:
real option managerial option
Given a level of investment in net working capital, that same investment must be _____ at some time in the future.
recovered
Erosion will ______ the sales of existing products.
reduce
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
Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:
the necessary financing