Ch. 9 Concepts
The basic approach to evaluating cash flow and NPV estimates involves asking:
what-if questions
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.
$400,00
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%, What is the "best case" for units sold per year?
1,000 * .15 = 150 1,000 + 150 = 1,150
Which of the following are fixed costs?
1. cost of equipment 2. rent on a production facility
We underestimate NPV because of the option(s) to ______.
1.) Abandon 2.) Expand
Cash flows used in project estimation should always reflect:
1.) After-tax cash flows 2.) Cash flows when they occur
Which of the following are considered relevant cash flows?
1.) Cash flows from external costs 2.) Cash flows from erosion effects 3.) Cash flows from beneficial spillover effects
The possibility that errors in projected cash flows will lead to incorrect decisions is known as:
1.) Forecasting risk 2.) Estimation risk
Estimates of which of the following are needed to prepare pro forma income statements?
1.) Selling price per unit 2.) Variable costs 3.) Unit Sales
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
True of false: The depreciation tax shield is the depreciation deduction divided by the tax rate.
False
True or false: Fixed costs cannot be changed over the life of the investment.
False
True or false: Sensitivity analysis is helpful because it indicates what we should do regarding forecasting errors.
False
The most valuable alternative that is given up if an investment is undertaken is called what?
Opportunity cost
Which of the following is an example of a sunk cost?
Project consultation fee
What is an example of an opportunity cost?
Rental income likely to be lost by using a vacant building for an upcoming project
_____ analysis is useful in pinpointing variables that deserve the most attention.
Sensitivity
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
The stand-alone principle assumes that evaluation of a project may be based on the project's ___ cash flows.
incremental
Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in _____.
net working capital
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
Scenario analysis considers a combination of factors for each scenario while _____ analysis focuses on only one variable at a time.
sensitivity
The depreciation tax _____ is the tax savings that results from the depreciation deduction.
shield
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
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
Synergy will _____ the sales of existing products
increase
Cash flows should always be considered on a(n) _______________ basis.
after-tax
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.
contigency
What is net working capital?
current assets - current liabilities
Incremental cash flows come about as a(n) _____ consequence of taking a project under consideration.
direct
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
What is an important drawback of traditional NPV analysis?
It ignores managerial options in investment decisions.
One of the most important steps in estimating cash flow is to determine the _____ cash flows.
relevant
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
1.) Book value represents the purchase price - the accumulated depreciation 2.) There will be a tax savings if the book value exceeds the sales price. 3.) Taxes are based on the difference between the book value and the sales price.
Which of the following are components of project cash flow?
1.) Capital spending 2.) Operating cash flow 3.) Change in net working capital
Investment in net working capital arises when ____.
1.) Cash is kept for unexpected expenditures 2.) Inventory is purchased 3.) Credit sales are made
The goals of risk analysis in capital budgeting include:
1.) Identifying critical components 2.) Assessing the degree of financing risk
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:
1.) It determines taxes owed on fixed assets when they are sold 2.) It determines the book value of assets which affects net salvage value 3.) It affects a firm's annual tax liability
What are the two main drawbacks of sensitivity analysis?
1.) It does not consider interaction among variables. 2.) It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.
True or false: Taxes are based on the difference between the initial cost and the sales price.
False
True or false: The value of managerial options is taken into account when performing conventional NPV analysis.
False
True or false: In calculating cash flows, you should consider all financing costs.
False *In analyzing a proposed investment, you should not include interest paid or any other financing costs
The number of positive NPV projects is unlimited for any given firm.
Fasle. *The positive NPV investments are not at all common and the number of positive NPV projects is certainly limited for any given firm
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 techniques will provide the most consistently correct result?
Net Present Value
The difference between a firm's current assets and its current liabilites is known as the ______.
Net working capital
Which of the following is the equation for estimating operating cash flows using the tax shield approach?
OCF = (sales - costs) x (1 - tax rate) + depreciation x 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
What approach does the following formula describe? OCF = (Sales - costs) x (1 - Tax rate) + depreciation x tax rate
The Tax Shield Approach
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
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: If analysts are overly optimistic about the future, then they may accept a project that realistically has a negative NPV.
True
The difference between a firm's cash flows with a project vs. 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
Side effects from investing in a project refer to cash flows from:
1.) Beneficial spillover effects 2.) Erosion effects
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
1.) It properly chooses among mutually exclusive projects 2.) It considers the riskiness of the project 3.) It considers time value of money 4.) It considers all the cash flows.
What are the two main benefits of performing sensitivity analysis?
1.) It reduces a false sense of security by giving a range of values for NPV instead of a single value. 2.) It identifies the variable that has the most effect on NPV.
An option on a real asset rather than a financial asset is known as a:
1.) Managerial Option 2.) Real option
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
1.) NPV 2.) IRR 3.) Payback Period
Identify the three main sources of cash flows over the life of a typical project.
1.) Net cash flows from salvage value at the end of the project 2.) Cash outflows from investment in plant and equipment at the inception of the project 3.) Net cash flows from sales and expenses over the life of the project.
A manager has estimated a positive NPV for a project. What could drive this result?
1.) Overly optimistic management 2.) The project is a good investment 3.) The cash flow estimations are inaccurate
Operating cash flow is a function of:
1.) Taxes 2.) Earnings before interest and taxes 3.) Depreciation
Which of the following qualify as "managerial options"?
1.) The option to abandon 2.) The option to wait 3.) The option to expand
Which of the following is true relative to capital rationing?
1.) hard rationing implies the firm is unable to raise funds for projects 2.) soft rationing is typically internal in that the firm allocates funds to divisions for capital projects
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.
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.
Opportunity costs are classified as _____ costs in project analysis.
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
To investigate the Impact on NPV of a change in one variable, you would employ ___.
sensitivity analysis
When using _____, all the variables except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable.
sensitivity analysis
Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:
the necessary funding
