Business Finance Ch 9

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

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

False

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.

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

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

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

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

True

Opportunity costs are ____.

benefits lost due to taking on a particular project

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

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

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

the necessary financing

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

False

True or false: In calculating cash flows, you should consider all financing costs.

False

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.

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

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

Project consultation fee

Investment in net working capital arises when ___.

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

The goals of risk analysis in capital budgeting include:

- assessing the degree of financing risk - identifying critical components

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

- real option - managerial option

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

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

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

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

1986 Tax Reform Act

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

False

What is an important drawback of traditional NPV analysis?

It ignores managerial options in investment decisions.

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.

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

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

direct

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

ignored

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

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

relevant

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 basic approach to evaluating cash flow and NPV estimates involves asking:

what-if questions

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

- Book value represents the purchase price minus the accumulated depreciation. - 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.

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.

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

- NPV - IRR - payback period

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

- forecasting risk - estimation risk

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 reasons why NPV is considered a superior capital budgeting technique?

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

Identify the three main sources of cash flows over the life of a typical 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 - Net cash flows from salvage value at the end of the project

Which of the following are components of project cash flow?

- Operating cash flow - Change in net working capital - Capital spending

Which of the following qualify as "managerial options"?

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

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

Cash flows used in project estimation should always reflect:

- after-tax cash flows - cash flows when they occur

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 determines taxes owed on fixed assets when they are sold - it affects a firm's annual tax liability