Chapter 9 - Making Capital Investment Decisions

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

1. forecasting risk 2. estimation risk

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

1. managerial option 2. real option

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

1986 Tax Reform Act

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.

Three main sources of cash flows over the life of a typical project:

1. cash outflows from investment in plant and equipment at the inception of the project. 2. net cash flows from sales and expenses over the life of the project. 3. net cash flows from salvage value at the end of the project.

Which of the following are fixed costs?

1. cost of equipment 2. rent on a production facility

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 are reasons why NPV is considered a superior capital budgeting technique?

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).

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

net working capital

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

relevant

In a competitive market, positive NPV projects are:

uncommon

Which of the following are considered relevant cash flows?

1. cash flows from erosion effects 2. cash flows from opportunity costs 3. cash flows from beneficial spillover effects

What are the two main drawbacks of sensitivity analysis?

1. it does not consider interaction among variable. 2. it may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.

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.

Which of the following are needed for cash flow estimation?

1. variable cost per unit 2. selling price per unit 3. unit sales per period

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 assessd the ____ of the cash flow estimates.

reliability

Opportunity costs are ___.

benefits lost due to taking on a particular project.

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

1. IRR 2. NPV 3. payback period

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

1. it determines the book value of assets which affects net salvage value 2. it determines taxes owed on fixed assets when they are sold 3. it affects a firm's annual tax liability

Which of the following are components of project cash flow?

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

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

1. overly optimistic management 2. the cash flow estimations are inaccurate 3. the project is a good investment

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

net working capital

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.

While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time. True or False?

True

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

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

1. beneficial spillover effects 2. erosion effects

Investment in net working capital arises when ____.

1. cash is kept for unexpected expenditures 2. credit sales are made 3. inventory is purchased

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

1. taxes are based on the difference between the book value and the sales price. 2. book value represents the purchase price minus the accumulated depreciation. 3. there will be a tax savings if the book value exceeds the sales price.

Since depreciation is a non-cash expense, it does not affect a project's cash flows. True or False?

False

Cash flows should always be considered on an ____ basis.

after-tax

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

The stand-along 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

Erosion will ____ the sales of existing products.

reduce

The goals of risk analysis in capital budgeting include:

1. assessing the degree of financing risk 2. identifying critical components

Which of the following qualify as managerial options?

1. the option to abandon 2. the option to wait 3. the option to expand

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

delay the launch of a good project.

Incremental cash flows come about as a _____ 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.

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

ignored

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

upper and lower bounds