Business Finance Chapter 9

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

false

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

estimation risk forecasting risk

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

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

increase

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

scenario analysis; asking what-if questions

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

sensitivity analysis

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

Which of the following are considered relevant cash flows?

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

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

Operating cash flow is a function of:

Earnings Before Interest and Taxes Depreciation Taxes

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

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

after-tax

Managerial options are taken into consideration in ____ planning.

contingency

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

Synergy will _____ the sales of existing products.

increase

The primary risk in estimation errors is the potential to ____

make incorrect capital budgeting 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

____ analysis is useful in pinpointing variables that deserve the most attention.

sensitivity

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

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

true

Which of the following qualify as "managerial options"?

The option to wait The option to expand The option to abandon

Cash flows used in project estimation should always reflect:

cash flows when they occur; after-tax cash flows

What is net working capital?

current assets minus current liabilities

True or false: Sensitivity analysis is helpful because it indicates what we should do regarding forecasting errors.

false

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

false

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

ignored

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

incremental cash flows

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

opportunity cost

The depreciation tax ____ is the tax savings that results from the depreciation deduction.

shield

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

Cash outflows from investment in plant and equipment at the inception of the 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

Which of the following are components of project cash flow?

Change in net working capital Operating cash flow Capital spending

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.

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

direct

The number of positive NPV projects is unlimited for any given firm.

false

Sunk costs are costs that ____.

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

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

net working capital

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

project consultation fee

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

relevant

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?

unit sales; variable costs; selling price per unit

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

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 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; Book value represents the purchase price minus the accumulated depreciation; There will be a tax savings if the book value exceeds the sales price.

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

erosion effects; beneficial spillover effects

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

In a competitive market, positive NPV projects are:

uncommon

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

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

the necessary financing

Investment in net working capital arises when ___.

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

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.

Opportunity costs are ____.

benefits lost due to taking on a particular project

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

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

1

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

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 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 an opportunity cost?

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

We underestimate NPV because of the option(s) to __

abandon; expand

The goals of risk analysis in capital budgeting include:

assessing the degree of financing risk identifying critical components

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 fixed costs?

cost of equipment; rent on a production facility

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

incremental

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

minus

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

net present value (NPV)

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

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

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. Overly optimistic management

Opportunity costs are classified as ____ costs in project analysis.

relevant

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.

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.

` True or false: The value of managerial options is taken into account when performing conventional NPV analysis.

false