Exam 11: Cash Flow Estimation and Risk Analysis

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.

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A) Shipping and installation costs.
B) Cannibalization effects.
C) Opportunity costs.
D) Sunk costs that have been expensed for tax purposes.
E) Changes in net working capital.

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A) In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV.
B) The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.
C) Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values.
D) As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.
E) Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

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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.

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A) Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
B) When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
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.

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A) Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.
B) It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion.Working capital like inventory is almost always used up in operations.Thus, cash flows associated with working capital should be included only at the start of a project's life.
C) If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit.In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.
D) Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities.Therefore, changes in net working capital should not be considered in a capital budgeting analysis.
E) If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

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A) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
B) A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices.
C) A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
D) If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.
E) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

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A) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers.Thus, cannibalization is dealt with by society through the antitrust laws.
B) If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects.Otherwise, the calculated NPV will be biased downward.
C) If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.
D) Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
E) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors.Thus, cannibalization is dealt with by society through the antitrust laws.

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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.

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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%.

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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.

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A) Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify.It is better to not risk adjust at all.
B) Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated.
C) Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV.Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables.This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure.
D) DCF techniques were originally developed to value passive investments (stocks and bonds) .However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow stream.Opportunities for such actions are called real options.Real options are valuable, but this value is not captured by conventional NPV analysis.Therefore, a project's real options must be considered separately.
E) The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs.Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

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A) An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.
B) The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not.This is another reason to favor the NPV.
C) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality.

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