Financial Management Ch. 9 Making Capital Investment Decisions

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

aftertax

Cash flows used in project estimation should always reflect:

cash flows when they occur. aftertax cash flows.

Managerial options are taken into consideration in Blank planning.

contingency

Operating cash flow is a function of:

depreciation. earnings before interest and taxes. taxes.

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

direct

The cash flows of a new project that come at the expense of a firm's existing projects is called .

erosion

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 value of managerial options is taken into account when performing conventional NPV analysis.

false

Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?

There will be a tax savings if the book value exceeds the sales price. Book value represents the purchase price minus the accumulated depreciation. Taxes are based on the difference between the book value and the sales price.

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 Blank______ as the base case.

$400,000

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 percent, what is the "worst case" for variable cost per unit?

$55

What is the total number of inputs that change at a given time while doing sensitivity analysis?

1

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 percent, 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 percent reversed.

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

1986 Tax Reform Act.

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.

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

IRR NPV payback period

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

It considers the riskiness of the project. It considers all the cash flows. It properly chooses among mutually exclusive projects. It considers time value of money.

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.

What are the two main drawbacks of sensitivity analysis?

It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive. It does not consider interaction among variables.

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

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.

What is scenario analysis?

Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

Blank analysis is useful in pinpointing variables that deserve the most attention. (Enter only one word per blank.)

Sensitivity

We underestimate NPV because of the option(s) to Blank______.

abandon expand

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.

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

The project is a good investment. The cash flow estimations are inaccurate. Management rationality could drive this result.

Opportunity costs are Blank______.

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.

An increase in depreciation expense will Blank______ cash flows from operations.

increase

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

incremental

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

incremental cash flows

Investment in net working capital arises when Blank______.

inventory is purchased cash is kept for unexpected expenditures credit sales are made

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

it determines the book value of assets which affects net salvage value it affects a firm's annual tax liability it determines taxes owed on fixed assets when they are sold

The primary risk in estimation errors is the potential to Blank______.

make incorrect capital budgeting decisions

An option on a real asset rather than a financial asset is known as a Blank______.

managerial option real option

Which of the following is an example of a sunk cost?

project consultation fee

Erosion will Blank______ the sales of existing products.

reduce

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

relevant

Opportunity costs are classified as Blank______ costs in project analysis.

relevant

The first step in estimating cash flow is to determine the Blank______ 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 Blank______ of the cash flow estimates.

reliability

When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in Blank______.

scenario analysis asking what-if questions

Scenario analysis considers a combination of factors for each scenario, while Blank analysis focuses on only one variable at a time.

sensitivity

The goals of risk analysis in capital budgeting include Blank______.

assessing the degree of financing risk identifying critical components

True or false: Taxes are based on the difference between the initial cost and the sales price.

false

True or false: The number of positive NPV projects is unlimited for any given firm.

false

The possibility that errors in projected cash flows will lead to incorrect decisions is known as Blank______.

forecasting risk estimation risk

Sunk costs are costs that Blank______.

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 Blank______ when computing cash flows from a project.

ignored

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

the tax-shield approach

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

minus

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

net present value

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

net working capital

Which of the following are components of project cash flow?

operating cash flow change in net working capital capital spending

To investigate the impact on NPV of a change in one variable, you would employ Blank______.

sensitivity analysis

When using Blank______, 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 Blank______ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

stand-alone

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

the necessary financing

Which of the following qualify as "managerial options"?

the option to expand the option to wait the option to abandon

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: 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

In a competitive market, positive NPV projects are Blank______.

uncommon

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

unit sales selling price per unit variable costs

In order to analyze the risk of a project's NPV estimate, we should establish Blank______ for each important estimate variable.

upper and lower bounds

The basic approach to evaluating cash flow and NPV estimates involves asking Blank______.

what-if questions