Exam 11: Cash Flow Estimation and Risk Analysis

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A) $28,115
B) $28,836
C) $29,575
D) $30,333
E) $31,092

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A) Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
B) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
C) Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
D) Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
E) Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

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A) $30,258
B) $31,770
C) $33,359
D) $35,027
E) $36,778

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A) Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
B) 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.
C) 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.
D) 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.
E) As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.

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A) Increase the estimated IRR of the project to reflect its greater risk.
B) Increase the estimated NPV of the project to reflect its greater risk.
C) Reject the project, since its acceptance would increase the firm's risk.
D) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
E) Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

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A) Project A, which has average risk and an IRR = 9%.
B) Project B, which has below-average risk and an IRR = 8.5%.
C) Project C, which has above-average risk and an IRR = 11%.
D) Without information about the projects' NPVs we cannot determine which project(s) should be accepted.
E) All of these projects should be accepted.

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A) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
B) A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
C) A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
D) Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.
E) A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.

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A) 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.
B) 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.
C) 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.
D) 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.
E) 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.
Problems
We designated many of these questions EASY or MEDIUM. This indicates that they are not conceptually hard. However, some of them require a good bit of arithmetic, which will lengthen the time it takes students to work them. We tried to use constant cash flows, straight-line depreciation (except where we wanted to illustrate accelerated depreciation) , and short project lives, but completing the cash flow estimation process still requires a good bit of arithmetic. This should not be important for take-home tests, but it should be considered when making up timed tests.

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A) All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
B) Interest on funds borrowed to help finance the project.
C) The end-of-project recovery of any working capital required to operate the project.
D) Cannibalization effects, but only if those effects increase the project's projected cash flows.
E) Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

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A) Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
B) One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
C) Well-diversified stockholders do not need to consider market risk when determining required rates of return.
D) Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
E) Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

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A) Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
B) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
C) Corporations must use the same depreciation method for both stockholder reporting and tax purposes.
D) Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.
E) Using accelerated depreciation rather than straight line normally has no effect on a project's total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project.

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A) $ 8,903
B) $ 9,179
C) $ 9,463
D) $ 9,746
E) $10,039

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