Chapter 13: Capital Budgeting- Estimating CF and Analyzing Risk
Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated? a. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. b. The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. c. The new product will cut into sales of some of the firm's other products. d. If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project's life. e. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.
b
A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated NPV of the project to reflect its greater risk. b. Reject the project, since its acceptance would increase the firm's risk. c. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. d. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. e. Increase the estimated IRR of the project to reflect its greater risk.
d
The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.
false
The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.
false
The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.
false
Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant.
false
A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.
true
Any cash flows that can be classified as incremental to a particular project⎯i.e., results directly from the decision to undertake the project⎯should be reflected in the capital budgeting analysis.
true
Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows.
true
If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.
true
If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.
true
In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows.
true
It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis.
true
Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.
true
The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.
true
When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. b. The value of a building owned by the firm that will be used for this project. c. A decline in the sales of an existing product, provided that decline is directly attributable to this project. d. The salvage value of assets used for the project that will be recovered at the end of the project's life. e. Changes in net working capital attributable to the project.
a
Which of the following rules is CORRECT for capital budgeting analysis? a. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. b. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. c. A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted. d. If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis. e. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.
a
Which of the following factors should be included in the cash flows used to estimate a project's NPV? a. Interest on funds borrowed to help finance the project. b. The end-of-project recovery of any working capital required to operate the project. c. Cannibalization effects, but only if those effects increase the project's projected cash flows. d. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. e. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. b. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. c. A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. d. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. e. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
c
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. Revenues from an existing product would be lost as a result of customers switching to the new product. b. Shipping and installation costs associated with a machine that would be used to produce the new product. c. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. d. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm e. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
c
To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is CORRECT? a. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. c. Capital budgeting decisions should be based on before-tax cash flows. d. The cost of capital used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. e. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the cost of capital. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.
e
Which of the following procedures best accounts for the relative risk of a proposed project? a. Adjusting the discount rate downward if the project is judged to have above-average risk. b. Reducing the NPV by 10% for risky projects. c. Picking a risk factor equal to the average discount rate. d. Ignoring risk because project risk cannot be measured accurately. e. Adjusting the discount rate upward if the project is judged to have above-average risk.
e
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. b. The company has spent and expensed $1 million on R&D associated with the new project. c. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. d. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. e. The new project is expected to reduce sales of one of the company's existing products by 5%.
e
Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.
false
Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.
false
Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital.
false
If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.
false
Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis.
false
Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions.
false
Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.
false
