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Chapter 13 CASH FLOW Estimation AND RISK Analysis
Financial Management and Control (Harvard University)
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
1. Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the
easiest step in the capital budgeting process.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
2. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
3. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
4. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom’s: Knowledge
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
5. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom’s: Knowledge
6. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Comprehension
7. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom’s: Knowledge
8. We can identify the cash costs and cash inflows to a company that will result from a project. These could be called
"direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do
not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of
the capital budgeting analysis.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom’s: Knowledge
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
9. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom’s: Knowledge
10. Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any
precision—estimates of its effect would really just be guesses. In this case, the externality should be ignored—i.e., not
considered at all—because if it were considered it would make the analysis appear more precise than it really is.
a. True
b. False
ANSWER:
False
RATIONALE: If the externality is potentially important, it should not be ignored, because then a large error might be
made. At the very least, it should be discussed, and possibly the analysis should be done using several
scenarios of its possible effects.
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom's: Comprehension
11. Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because
capital budgeting relates to fixed assets, not working capital.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Changes in NOWC
KEYWORDS: Bloom’s: Knowledge
12. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-2 Analysis of an Expansion Project
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
TOPICS:
KEYWORDS:
Depreciation cash flows
Bloom's: Comprehension
13. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
14. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
15. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
16. Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus
increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current
year's profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using
different depreciation methods for tax and stockholder reporting purposes.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
17. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-4 Risk Analysis in Capital Budgeting
TOPICS:
Risk-adjusted discount rate
KEYWORDS: Bloom’s: Knowledge
18. 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 for capital
budgeting projects.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
19. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
20. The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator
should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash
flows should be considered when making accept/reject decisions for capital budgeting projects.
a. True
b. False
ANSWER:
False
POINTS:
1
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
MODERATE
13-1 Conceptual Issues in Cash Flow Estimation
Relevant cash flows
Bloom’s: Knowledge
21. 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.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Opportunity costs
KEYWORDS: Bloom’s: Knowledge
22. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
TOPICS:
Sunk costs
KEYWORDS: Bloom's: Comprehension
23. The change in net operating working capital associated with new projects is always positive, because new projects
mean that more operating working capital will be required.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
NOWC
KEYWORDS: Bloom's: Comprehension
24. 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.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
25. Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected
by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent
variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the
more risky the project, other things held constant.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-5 Measuring Stand-Alone Risk
TOPICS:
Sensitivity analysis
KEYWORDS: Bloom's: Comprehension
26. Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true
regardless of whether the projects are mutually exclusive or independent of one another.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-7 Unequal Project Lives
TOPICS:
Replacement chain
KEYWORDS: Bloom’s: Comprehension
27. Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different
lives, it is not used in practice because not projects meet the assumptions the method requires.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-7 Unequal Project Lives
TOPICS:
Replacement chains
KEYWORDS: Bloom’s: Knowledge
28. Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically
appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their
initial lives.
a. True
b. False
ANSWER:
True
POINTS:
1
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
MODERATE
13-7 Unequal Project Lives
Common-life comparisons
Bloom’s: Knowledge
29. The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach
and (2) the equivalent annual annuity (EAA) approach.
a. True
b. False
ANSWER:
True
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-7 Unequal Project Lives
TOPICS:
Common life and EAA
KEYWORDS: Bloom’s: Knowledge
30. The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach
and (2) the present value approach.
a. True
b. False
ANSWER:
False
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-7 Unequal Project Lives
TOPICS:
Common life and EAA
KEYWORDS: Bloom’s: Knowledge
31. Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital
budgeting project?
a. Changes in net operating working capital.
b. Shipping and installation costs for machinery
acquired.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.
ANSWER:
e
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Cash flow issues
KEYWORDS: Bloom's: Comprehension
32. The relative risk of a proposed project is best accounted for by which of the following procedures?
a. Adjusting the discount rate upward if the project is judged to have above-average risk.
b. Adjusting the discount rate upward if the project is judged to have below-average risk.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.
ANSWER:
a
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-4 Risk Analysis in Capital Budgeting
TOPICS:
Risk adjustment
KEYWORDS: Bloom's: Comprehension
33. Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for
above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the
company uses the NPV method when choosing projects?
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 one or ones should be
accepted.
e. All of these projects should be accepted as they will produce a positive NPV.
ANSWER:
b
POINTS:
1
DIFFICULTY: EASY
REFERENCES: 13-4 Risk Analysis in Capital Budgeting
TOPICS:
Risk and project selection
KEYWORDS: Bloom's: Evaluation
34. Which of the following statements is CORRECT?
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 once the NPV method came into wide use, it became possible
to simply include sunk costs in the cash flows and then calculate the project's NPV.
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.
ANSWER:
c
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Sunk costs
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
35. Which of the following statements is CORRECT?
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been
depleted.
b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
c. 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.
d. 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.
e. 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 have been had the sunk costs been ignored.
ANSWER:
d
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Sunk costs
KEYWORDS: Bloom's: Application
OTHER:
Multiple Choice: Conceptual
36. Which of the following statements is CORRECT?
a. 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.
b. 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.
c. 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.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically
identified. However, the payback method does not.
e. Identifying an externality can never lead to an increase in the calculated NPV.
ANSWER:
b
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom's: Application
OTHER:
Multiple Choice: Conceptual
37. Which of the following statements is CORRECT?
a. 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.
b. 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 increase.
c. 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.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically
identified. However, the payback method does not.
e. Identifying an externality can never lead to an increase in the calculated NPV.
ANSWER:
b
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
38. Which of the following statements is CORRECT?
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 competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
b. 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.
c. 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.
d. 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.
e. 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.
ANSWER:
e
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Externalities
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
39. Which of the following statements is CORRECT?
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.
ANSWER:
a
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
KEYWORDS:
OTHER:
Bloom's: Comprehension
Multiple Choice: Conceptual
40. Which of the following statements is CORRECT?
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 the effect of slowing down cash flows
and thus reducing a project's forecasted NPV.
ANSWER:
d
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
41. Which of the following statements is CORRECT?
a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant
input, depreciation plays no role in capital budgeting.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives
are 3 years or longer.
c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line
depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line
depreciation were required for tax purposes.
d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line
depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line
depreciation were required for tax purposes.
e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line
depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line
depreciation were required for tax purposes.
ANSWER:
e
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
Depreciation
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
42. Other things held constant, which of the following would increase the NPV of a project being considered?
a. A shift from straight-line to MACRS depreciation.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
b. Making the initial investment in the first year rather than spreading it over the first three
years.
c. An increase in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. The project would decrease sales of another product line.
ANSWER:
a
POINTS:
1
DIFFICULTY: EASY/MODERATE
REFERENCES: 13B Tax Depreciation
TOPICS:
NPV and depreciation
KEYWORDS: Bloom's: Evaluation
OTHER:
Multiple Choice: Conceptual
43. A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash
flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal
cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors
should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
a. All sunk costs that have been incurred relating to the project.
b. All interest expenses on debt used to help finance the project.
c. The additional investment in net operating working capital required to operate the project, even if that
investment will be recovered at the end of the project's life.
d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the
current year.
e. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash
flows.
ANSWER:
c
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
44. Which of the following factors should be included in the cash flows used to estimate a project's NPV?
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 additional net operating 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.
ANSWER:
c
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
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KEYWORDS:
OTHER:
Bloom's: Analysis
Multiple Choice: Conceptual
45. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those
costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product, provided that decline is directly attributable to this project.
e. The salvage value of assets used for the project that will be recovered at the end of the project's life.
ANSWER:
b
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
46. Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward
with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear—there
is no mortgage on it. Which of the following statements is CORRECT?
a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it
should not be reflected in the cash flows of the capital budgeting analysis for any new project.
b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be
charged as a cost to any new project that would use it.
c. This is an example of an externality, because the very existence of the building affects the cash flows for any
new project that Rowell might consider.
d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new
projects are being evaluated, even if it would be used by those new projects.
e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new
project that used the building.
ANSWER:
b
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Application
OTHER:
Multiple Choice: Conceptual
47. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed
project?
a. The new project is expected to reduce sales of one of the company's existing products by 5%.
b. 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.
c. The company has spent and expensed $1 million on research and development costs associated with the new
project.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
d. The company spent and expensed $10 million on a marketing study before its current analysis regarding
whether to accept or reject the project.
e. 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.
ANSWER:
a
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
48. Dalrymple Inc. is considering production of 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 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. 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.
c. The company has spent and expensed for tax purposes $3 million on research related to the new product.
These funds cannot be recovered, but the research may benefit other projects that might be proposed in the
future.
d. The new product will cut into sales of some of the firm's other products.
e. If the project is accepted, the company must invest an additional $2 million in net operating working capital.
However, all of these funds will be recovered at the end of the project's life.
ANSWER:
c
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Evaluation
OTHER:
Multiple Choice: Conceptual
49. Which of the following rules is CORRECT for capital budgeting analysis?
a. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash
flows.
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant
when making accept/reject decisions for capital budgeting projects.
c. 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.
d. 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.
e. 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.
ANSWER:
b
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POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE
13-1 Conceptual Issues in Cash Flow Estimation
Relevant cash flows
Bloom's: Comprehension
Multiple Choice: Conceptual
50. Which of the following statements is CORRECT?
a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt,
failure to include interest expense as a cost when determining the project's cash flows will lead to an upward
bias in the NPV.
b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt,
failure to include interest expense as a cost when determining the project's cash flows will lead to a downward
bias in the NPV.
c. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist
without the externality.
d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be
sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be
obtained should be charged as a cost to the project under consideration.
e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then
any costs associated with that asset is a sunk cost and should be ignored.
ANSWER:
d
RATIONALE: Regarding a and b, note that since interest should not be considered, exclusion will not lead to any type
of bias, positive or negative.
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Relevant cash flows
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
51. 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 firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural
purposes.
b. 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.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the
new machinery.
d. A firm has spent $2 million on research and development 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.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's
other products.
ANSWER:
d
POINTS:
1
DIFFICULTY: MODERATE
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REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
13-1 Conceptual Issues in Cash Flow Estimation
Incremental cash flows
Bloom's: Analysis
Multiple Choice: Conceptual
52. 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. 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.
b. Revenues from an existing product would be lost as a result of customers switching to the new product.
c. Shipping and installation costs associated with a machine that would be used to produce the new product.
d. 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.
e. 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.
ANSWER:
d
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-1 Conceptual Issues in Cash Flow Estimation
TOPICS:
Incremental cash flows
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
53. A company is considering a proposed new plant that would increase productive capacity. Which of the following
statements is CORRECT?
a. 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 WACC. If interest were deducted
when estimating cash flows, this would, in effect, "double count" it.
b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating
the operating cash flows.
c. 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.
d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a
before-tax basis.
e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax
basis. To do otherwise would bias the NPV upward.
ANSWER:
a
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-2 Analysis of an Expansion Project
TOPICS:
New project cash flows
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
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54. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company
estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted
thorough scenario and simulation analyses. This research produced the following data:
Expected NPV
Standard deviation (σNPV)
Project beta (vs. market)
Correlation of the project cash flows
with cash flows from currently existing
projects
Project X
$350,000
$100,000
1.4
Project Y
$350,000
$150,000
0.8
Cash flows are not correlated with the
cash flows from existing projects
Cash flows are highly correlated with
the cash flows from existing projects
Which of the following statements is CORRECT?
a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of
existing projects.
ANSWER:
c
RATIONALE: Statement c is true, while the other statements are false. Stand-alone risk is measured by standard
deviation. Therefore, since Y's standard deviation is higher than X's, Y has higher stand-alone risk than
X. Statement b is false because corporate risk is affected by the correlation of project cash flows with
other company cash flows, and since Y's cash flows are more highly correlated with the cash flows of
existing projects than X's, Y has more corporate risk than X. Market risk is measured by beta. Therefore,
since X's beta is greater than Y's, statement c is true.
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-4 Risk Analysis in Capital Budgeting
TOPICS:
Risk analysis
KEYWORDS: Bloom's: Evaluation
OTHER:
Multiple Choice: Conceptual
55. Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall
economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of
variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they
would be high when the overall economy is down and low when the overall economy is strong. On the basis of this
information, which of the following statements is CORRECT?
a. The proposed new project would have more stand-alone risk than the firm's typical
project.
b. The proposed new project would increase the firm's corporate risk.
c. The proposed new project would increase the firm's market risk.
d. The proposed new project would not affect the firm's risk at all.
e. The proposed new project would have less stand-alone risk than the firm's typical project.
ANSWER:
a
RATIONALE: Statement a is true because the project has a relatively high standard deviation and thus more stand-alone
risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other
firms' revenues; hence, its within-firm and market risks would be relatively low.
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POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE
13-4 Risk Analysis in Capital Budgeting
Risk analysis
Bloom's: Application
Multiple Choice: Conceptual
56. 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 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.
ANSWER:
e
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-4 Risk Analysis in Capital Budgeting
TOPICS:
Project's effect on firm risk
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
57. Which of the following statements is CORRECT?
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.
ANSWER:
e
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-5 Measuring Stand-Alone Risk
TOPICS:
Risk techniques
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
58. Which of the following statements is CORRECT?
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.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
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 than sensitivity analysis.
ANSWER:
a
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13-5 Measuring Stand-Alone Risk
TOPICS:
Risk techniques
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
59. Which of the following statements is CORRECT?
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 operating working capital required at the start of an
expansion project can be recovered at the project's completion. Operating working capital like inventory is
almost always used up in operations. Thus, cash flows associated with operating 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 operating working capital refer to changes in current assets and current liabilities, not to
changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.
ANSWER:
d
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS:
CFs and accounting measures
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Conceptual
60. Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated
depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce
a. Higher depreciation charges in the early years of an asset's life.
b. Larger cash flows in the earlier years of an asset's life.
c. Larger total undiscounted profits from the project over the project's life.
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
d. Smaller accounting profits in the early years, assuming the company uses the same depreciation method for
tax and book purposes.
e. Lower tax payments in the earlier years of an asset's life.
ANSWER:
c
POINTS:
1
DIFFICULTY: MODERATE
REFERENCES: 13B Tax Depreciation
TOPICS:
Depreciation cash flows
KEYWORDS: Bloom's: Comprehension
OTHER:
Multiple Choice: Conceptual
61. As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data.
What is the Year 1 cash flow?
Sales revenues
Depreciation
Other operating costs
Tax rate
a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568
ANSWER:
a
RATIONALE: Sales revenues
− Operating costs (excl. deprec.)
− Depreciation
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 1
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
$13,000
$4,000
$6,000
35.0%
$13,000
6,000
4,000
$ 3,000
1,050
$ 1,950
4,000
$ 5,950
1
EASY
13-2 Analysis of an Expansion Project
Annual CF
Bloom's: Analysis
Multiple Choice: Problem
62. Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1
cash flow?
Sales revenues
Depreciation
Other operating costs
Tax rate
a. $ 8,903
$22,250
$8,000
$12,000
35.0%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
b. $ 9,179
c. $ 9,463
d. $ 9,746
e. $10,039
ANSWER:
c
RATIONALE: Sales revenues
− Operating costs (excl. deprec.)
− Depreciation
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 1
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
$22,250
12,000
8,000
$ 2,250
788
$ 1,463
8,000
$ 9,463
1
EASY
13-2 Analysis of an Expansion Project
Annual CF
Bloom's: Analysis
Multiple Choice: Problem
63. Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax
life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and
other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?
Equipment cost (depreciable basis)
Straight-line depreciation rate
Sales revenues, each year
Operating costs (excl. depreciation)
Tax rate
a. $28,115
b. $28,836
c. $29,575
d. $30,333
e. $31,092
ANSWER:
d
RATIONALE: Equipment life, years
Equipment cost
Depreciation: Rate = 33.333%
Sales revenues
− Basis × rate = depreciation
− Operating costs (excl. deprec.)
Operating income (EBIT)
− Taxes
Rate = 35.0%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 1
POINTS:
$65,000
33.333%
$60,000
$25,000
35.0%
3
$65,000
$21,667
$60,000
21,667
25,000
$13,333
4,667
$ 8,667
21,667
$30,333
1
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DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
EASY
13-2 Analysis of an Expansion Project
Annual CF
Bloom's: Analysis
Multiple Choice: Problem
64. As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with
the following data. What is the Year 1 cash flow?
Sales revenues, each year
$42,500
Depreciation
$10,000
Other operating costs
$17,000
Interest expense
$4,000
Tax rate
35.0%
a. $16,351
b. $17,212
c. $18,118
d. $19,071
e. $20,075
ANSWER:
e
RATIONALE: This problem is a bit harder than some of the other ones because it provides information on interest, and
some students might incorrectly include it as an input. We like this wrinkle because it's important for
students to know not to include financing costs in the calculation of cash flows since they will be
discounted at the WACC in determining a project's NPV.
Sales revenues
$42,500
− Operating costs (excl. deprec.)
17,000
− Depreciation
10,000
Operating income (EBIT)
$15,500
− Taxes
Rate = 35%
5,425
EBIT(1 − T)
$10,075
+ Depreciation
10,000
Cash flow, Year 1
$20,075
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
EASY/MODERATE
13-2 Analysis of an Expansion Project
Annual CF
Bloom's: Analysis
Multiple Choice: Problem
65. You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's
Year 1 cash flow?
Sales revenues, each year
Depreciation
Other operating costs
Interest expense
Tax rate
a. $25,816
$62,500
$8,000
$25,000
$8,000
35.0%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
b. $27,175
c. $28,534
d. $29,960
e. $31,458
ANSWER:
b
RATIONALE: This problem is a bit harder than some of the other ones because it provides information on interest, and
some students might incorrectly include it as an input. We like this wrinkle because it's important for
students to know not to include financing costs in the cash flows.
Sales revenues
$62,500
− Operating costs (excl. deprec.)
25,000
− Depreciation
8,000
Operating income (EBIT)
$29,500
− Taxes
Rate = 35%
10,325
EBIT(1 − T)
$19,175
8,000
+ Depreciation
Cash flow, Year 1
$27,175
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
EASY/MODERATE
13-2 Analysis of an Expansion Project
Annual CF
Bloom's: Analysis
Multiple Choice: Problem
66. Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has
a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4.
Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1
cash flow?
Equipment cost (depreciable basis)
Sales revenues, each year
Operating costs (excl. depreciation)
Tax rate
a. $30,258
b. $31,770
c. $33,359
d. $35,027
e. $36,778
ANSWER:
a
$65,000
$60,000
$25,000
35.0%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
RATIONALE:
Equipment cost
Depreciation rate
Sales revenues
− Operating costs (excl. deprec.)
− Depreciation
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 1
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
EASY/MODERATE
13-2 Analysis of an Expansion Project
Annual CF; MACRS
Bloom's: Analysis
Multiple Choice: Problem
$65,000
33.0%
$60,000
25,000
21,450
$13,550
4,743
$ 8,808
21,450
$30,258
67. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a
3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues
and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the
project's Year 4 cash flow?
Equipment cost (depreciable basis)
Sales revenues, each year
Operating costs (excl. depreciation)
Tax rate
a. $11,814
b. $12,436
c. $13,090
d. $13,745
e. $14,432
ANSWER:
c
RATIONALE: Equipment cost
Depreciation rate, Year 4
Sales revenues
− Operating costs (excl. deprec.)
− Depreciation
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
Cash flow, Year 4
POINTS:
DIFFICULTY:
TOPICS:
KEYWORDS:
OTHER:
$70,000
$42,500
$25,000
35.0%
$70,000
7.0%
$42,500
25,000
4,900
$12,600
4,410
$ 8,190
4,900
$13,090
1
MODERATE
Annual CF; MACRS
Bloom's: Analysis
Multiple Choice: Problem
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
68. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value.
No change in net operating working capital would be required. Revenues and other operating costs are expected to be
constant over the project's 3-year life. What is the project's NPV?
Risk-adjusted WACC
Net investment cost (depreciable basis)
Straight-line depreciation rate
Sales revenues, each year
Annual operating costs (excl. depreciation)
Tax rate
a. $15,740
b. $16,569
c. $17,441
d. $18,359
e. $19,325
ANSWER:
e
10.0%
Years
RATIONALE: WACC
Investment cost
Sales revenues
− Operating costs (excl. deprec.)
− Depreciation Rate = 33.333%
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
Project CFs
NPV
$19,325
POINTS:
DIFFICULTY:
TOPICS:
KEYWORDS:
OTHER:
10.0%
$65,000
33.3333%
$65,500
$25,000
35.0%
0
−$65,000
−$65,000
1
$65,500
25,000
21,667
$18,833
6,592
$12,242
21,667
$33,908
2
$65,500
25,000
21,667
$18,833
6,592
$12,242
21,667
$33,908
3
$65,500
25,000
21,667
$18,833
6,592
$12,242
21,667
$33,908
1
MODERATE
Project NPV
Bloom's: Analysis
Multiple Choice: Problem
69. Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75%
has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the
equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value
is less than its book value, the firm will receive a tax credit as a result of the sale.
a. $5,558
b. $5,850
c. $6,143
d. $6,450
e. $6,772
ANSWER:
b
RATIONALE: % depreciated on equip.
75%
Tax rate
40%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
Equipment cost
− Accumulated deprec.
Current book value of equipment
Market value of equipment
Gain (or loss): Market value − Book value
Taxes paid on gain (−) or credited (+) on loss
AT salvage value = market value +/− taxes
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
$22,500
16,875
$ 5,625
6,000
$ 375
−150
$ 5,850
1
MODERATE
13-2 Analysis of an Expansion Project
Salvage value
Bloom's: Analysis
Multiple Choice: Problem
70. Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a
tax life of 5 years, and it can be depreciated according to the depreciation rates below. The firm expects to operate the
machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be
when the machine is sold at the end of Year 4?
Year
1
2
3
4
5
6
a. $ 8,878
b. $ 9,345
c. $ 9,837
d. $10,355
e. $10,900
ANSWER:
e
RATIONALE:
Year
1
2
3
4
5
6
Depreciation Rate
0.20
0.32
0.19
0.12
0.11
0.06
Deprec.
Rate
0.20
0.32
0.19
0.12
0.11
0.06
1.00
Basis
$50,000
50,000
50,000
50,000
50,000
50,000
Annual
Year-end
Deprec.
Book Value
$10,000
$40,000
16,000
24,000
9,500
14,500
6,000
8,500
5,500
3,000
3,000
0
$50,000
Gross sales proceeds
Book value, end of Year 4
Profit
Tax on profit
Rate = 40%
AT salvage value = market value +/− taxes
POINTS:
$12,500
8,500
$ 4,000
1,600
$10,900
1
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
MODERATE
13-2 Analysis of an Expansion Project
Salvage value
Bloom's: Analysis
Multiple Choice: Problem
71. Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0.
Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,800 at the end of Years 1 and 2,
respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has
an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a
WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project?
a. $4,242
b. $4,246
c. $4,286
d. $4,325
e. $4,433
ANSWER:
d
RATIONALE: WACC = 8.00%
Project X CFs
Extended CFs
Total Project X CFs
0_
-10,000
_
-10,000
1
6,000
_
6,000
2_
7,900
-10,000
-2,100
3
6,000
6,000
1
4,300
2_
4,300
3
4,300
4
7,900
7,900
Project X, extended NPV = $4,324.87
Project Y CFs
0_
-10,000
4
4,300
Project Y, NPV = $4,242.15
NPV of most profitable project, Project X = $4,324.87 » $4,325.
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE
13-7 Unequal Project Lives
Replacement chain approach
Bloom's: Analysis
Multiple Choice: Problem
72. Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0.
Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2,
respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has
an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a
WACC of 11%. What is the equivalent annual annuity of the most profitable project?
a. $1,345.50
b. $1,346.30
c. $1,361.52
d. $1,376.74
e. $1,411.15
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
ANSWER:
RATIONALE:
d
WACC = 11.00%
Project X CFs
0_
-10,000
1
6,000
2
8,500
1
4,600
2
4,600
Project X, NPV = $2,304.20
Determine Project X EAA:
N
2
I/YR
11.00%
PV
$2,304.20
FV
0
PMT = EAAX
Project Y CFs
$1,345.50
0_
-10,000
3
4
4,600
4,600
Project Y, NPV = $4,271.25
Determine Project Y EAA:
N
4
I/YR
11.00%
PV
$4,271.25
FV
0
PMT = EAAY
$1,376.74
EAA of most profitable project, Project Y = $1,376.74
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE
13-7 Unequal Project Lives
Equivalent annual annuity
Bloom's: Analysis
Multiple Choice: Problem
73. Carlyle Inc. is considering two mutually exclusive projects. Both require an initial investment of $15,000 at t = 0.
Project S has an expected life of 2 years with after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2,
respectively. In addition, Project S can be repeated at the end of Year 2 with no changes in its cash flows. Project L has
an expected life of 4 years. Each project has a WACC of 9%. What is the equivalent annual annuity of the most
profitable project?
a. $569.67
b. $792.34
c. $865.31
d. $1,522.18
e. $1,846.54
ANSWER:
c
RATIONALE: WACC = 9.00%
Project S:
CFs
NPVS
EAAS:
0_
-$15,000
1 _
$7,000
2
$12,000
$1,522.18
Enter the following inputs in your financial calculator:
N = 2; I/YR = 9; PV = -1522.18; FV = 0; and solve for PMT = EAA = $865.31.
Project L:
0_
1
2
3
4
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
CFs
-$15,000
$5,200
$5,200
$5,200
$5,200
NPVL
$1,846.54
EAAL:
Enter the following inputs in your financial calculator:
N = 4; I/YR = 9; PV = -1846.54; FV = 0; and solve for PMT = EAA = $569.97.
The most profitable project is the one with the higher EAA. Since EAAS > EAAL, choose Project S with EAA =
$865.31.
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE
13-7 Unequal Project Lives
Equivalent annual annuity
Bloom’s: Analysis
Multiple Choice: Problem
74. TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be
depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no change in net
operating working capital would be required. Revenues and other operating costs are expected to be constant over the
project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax
annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1–3.)
WACC
Pre-tax cash flow reduction for other products (cannibalization)
Investment cost (depreciable basis)
Straight-line depreciation rate
Annual sales revenues
Annual operating costs (excl. depreciation)
Tax rate
a. $3,636
b. $3,828
c. $4,019
d. $4,220
e. $4,431
ANSWER:
b
RATIONALE:
Investment (Basis)
Sales revenues
− Cannibalization cost
− Operating costs (excl. deprec.)
− Basis × rate = deprec.
Operating income (EBIT)
− Taxes
EBIT(1 − T)
+ Depreciation
Project CFs
NPV
WACC = 10%
10.0%
−$5,000
$80,000
33.333%
$67,500
−$25,000
35.0%
t=0
$80,000
Rate = 33.33%
Rate = 35%
−$80,000
t=1
t=2
t=3
$67,500
− 5,000
−25,000
−26,667
$10,833
3,792
$ 7,042
26,667
$33,708
$67,500
− 5,000
−25,000
−26,667
$10,833
3,792
$ 7,042
26,667
$33,708
$67,500
− 5,000
−25,000
−26,667
$10,833
3,792
$ 7,042
26,667
$33,708
$3,828
POINTS:
1
DIFFICULTY: MODERATE/CHALLENGING
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REFERENCES 13-2 Analysis of an Expansion Project
:
TOPICS:
Project NPV
KEYWORDS: Bloom's: Analysis
OTHER:
Multiple Choice: Problem
75. Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns
the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The
equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it
would be worth nothing and thus it would have a zero salvage value. No change in net operating working capital would be
required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's
NPV? (Hint: Cash flows are constant in Years 1–3.)
WACC
Opportunity cost
Net equipment cost (depreciable basis)
Straight-line depreciation rate for equipment
Annual sales revenues
Annual operating costs (excl. depreciation)
Tax rate
a. $10,521
b. $11,075
c. $11,658
d. $12,271
e. $12,885
ANSWER:
d
RATIONALE:
Investment
Opportunity cost
Revenues
10.0%
$100,000
$65,000
33.333%
$123,000
$25,000
35%
WACC = 10%
t=1
t=2
t=3
$123,000
$123,000
$123,000
−25,000
−25,000
−25,000
− Operating costs (excl. deprec.)
Rate =
− Basis × rate = deprec.
33.33%
Operating income (EBIT)
− Taxes
Rate = 35%
−21,667
−21,667
−21,667
$ 76,333
−26,717
$ 76,333
−26,717
$ 76,333
−26,717
EBIT(1 − T)
$ 49,617
$ 49,617
$ 49,617
21,667
$ 71,283
21,667
$ 71,283
21,667
$ 71,283
+ Depreciation
_________
−$165,000
Project CFs
NPV
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
t=0
−$ 65,000
−100,000
$12,271
1
MODERATE/CHALLENGING
13-2 Analysis of an Expansion Project
Project NPV
Bloom's: Analysis
Multiple Choice: Problem
76. Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0.
Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2,
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next
4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. The
controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is
selected over Project S, i.e., what is the value of NPVL - NPVS?
a. $56.50
b. $62.15
c. $68.37
d. $75.21
e. $82.73
ANSWER:
a
RATIONALE: WACC = 9.25%
Project S:
CFs
Extended CFs
Total CFs
0
-$10,000
1
$6,000
-$10,000
$6,000
2
$ 8,000
-10,000
-$ 2,000
0
-$10,000
1
$4,373
2
$4,373
3
$6,000
$6,000
4
$8,000
$8,000
NPVS = $4,033.40
Project L:
CFs
3
$4,373
4
$4,373
NPVL = $4,089.90
NPVL – NPVS = $56.50
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
1
MODERATE/CHALLENGING
13-7 Unequal Project Lives
Replacement chain approach
Bloom’s: Evaluation
Multiple Choice: Problem
77. Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be
constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise
with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no
salvage value. No change in net operating working capital would be required. This is just one of many projects for the
firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV?
WACC
Net investment cost (depreciable basis)
Units sold
Average price per unit, Year 1
Fixed oper. costs excl. depreciation (constant)
Variable oper. cost/unit, Year 1
Annual depreciation rate
Expected inflation rate per year
Tax rate
a. $15,925
b. $16,764
c. $17,646
d. $18,528
10.0%
$200,000
50,000
$25.00
$150,000
$20.20
33.333%
5.00%
40.0%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
e. $19,455
ANSWER:
c
RATIONALE: Base Case Calculations
Investment cost
WACC = 10%
Inflation
Price per unit
VC per unit
Units sold
Sales revenues
– Fixed op. cost (excl. deprec.)
– Variable op. costs
– Depreciation
Rate = 33.333%
Operating income (EBIT)
– Taxes
EBIT(1 – T)
+ Depreciation
Project CFs
NPV
$17,646
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
t=0
−$200,000
t=1
t=2
t=3
5.0%
$25.00
$20.20
50,000
$1,250,000
150,000
1,010,000
66,667
$ 23,333
9,333
$ 14,000
66,667
5.0%
$26.25
$21.21
50,000
$1,312,500
150,000
1,060,500
66,667
$ 35,333
14,133
$ 21,200
66,667
$ 87,867
5.0%
$27.56
$22.27
50,000
$1,378,125
150,000
1,113,525
66,667
$ 47,933
19,173
$ 28,760
66,667
$ 95,427
−$200,000
$
80,667
1
CHALLENGING
13-2 Analysis of an Expansion Project
NPV including inflation
Bloom's: Analysis
Multiple Choice: Problem
78. Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be
constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise
with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no
salvage value. No change in net operating working capital would be required. This is just one of many projects for the
firm, so any losses on this project can be used to offset gains on other firm projects. The marketing manager does not
think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the
CFO thinks an inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is
made versus if it is not made?
WACC
Net investment cost (depreciable basis)
Units sold
Average price per unit, Year 1
Fixed oper. costs excl. depreciation (constant)
Variable oper. cost/unit, Year 1
Annual depreciation rate
Expected inflation
Tax rate
a. $12,018
b. $12,650
c. $13,316
d. $13,982
e. $14,681
ANSWER:
c
RATIONALE: NPV with no adjustment
10.0%
$200,000
50,000
$25.00
$150,000
$20.20
33.333%
4.00%
40.0%
t=0
t=1
t=2
t=3
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
Investment cost
WACC
= 10%
−$200,000
0.0%
$25.00
$20.20
49,000
0.0%
$25.00
$20.20
49,000
0.0%
$25.00
$20.20
49,000
$1,225,000 $1,225,000
150,000
150,000
989,800
989,800
66,667
66,667
$1,225,000
150,000
989,800
66,667
$
18,533 $
7,413
18,533
7,413
$
$
11,120 $ 11,120
66,667
66,667
77,787 $ 77,787
$
Inflation (set to 0%)
Price per unit
VC per unit
Units sold
Sales revenues
− Fixed op. cost (excl. deprec.)
− Variable op costs
per unit = $20.20
Rate =
− Depreciation
33.3%
Operating income (EBIT)
Rate =
− Taxes
40%
EBIT(1 − T)
+ Depreciation
− $
$200,000
Project CFs
NPV w/o infl. adjustment
18,533
7,413
11,120
66,667
$ 77,787
−$6,556
NPV with adjustment
Investment cost
WACC
= 10%
t=0
−$200,000
t=1
t=2
t=3
4.0%
$25.00
$20.20
49,000
4.0%
$26.00
$21.01
49,000
4.0%
$27.04
$21.85
49,000
$1,225,000 $1,274,000
150,000
150,000
989,800 1,029,392
66,666
66,666
$1,324,960
150,000
1,070,568
66,666
$
27,942
11,177
$
11,120 $ 16,765
66,666
66,666
− $ 77,786 $ 83,431
$200,000
$
Inflation (set to 0%)
Price per unit
VC per unit
Units sold
Sales revenues
− Fixed op. cost (excl. deprec.)
− Variable op costs
per unit = $20.20
Rate =
− Depreciation
33.3%
Operating income (EBIT)
Rate =
− Taxes
40%
EBIT(1 − T)
+ Depreciation
Project CFs
NPV w/infl. adjustment
Increase w/infl. adjustment
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
18,534 $
7,414
$
37,726
15,091
22,636
66,666
$ 89,302
$6,760
$13,316
1
CHALLENGING
13-2 Analysis of an Expansion Project
NPV including inflation
Bloom's: Evaluation
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
OTHER:
Multiple Choice: Problem
79. Foley Systems is considering a new investment whose data are shown below. The equipment would be depreciated on
a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require additional net
operating working capital that would be recovered at the end of the project's life. Revenues and other operating costs are
expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows from operations are constant
in Years 1 to 3.)
WACC
Net investment in fixed assets (basis)
Required net operating working capital
Straight-line depreciation rate
Annual sales revenues
Annual operating costs (excl. depreciation)
Tax rate
a. $23,852
b. $25,045
c. $26,297
d. $27,612
e. $28,993
ANSWER:
a
RATIONALE:
10.0%
$75,000
$15,000
33.333%
$75,000
$25,000
35.0%
Investment in fixed assets
WACC = 10%
Investment in NOWC
Sales revenues
− Operating costs (excl. deprec.)
Depreciation
Rate = 33.333%
Operating income (EBIT)
− Taxes
Rate = 35%
EBIT(1 − T)
+ Depreciation
EBIT(1 − T) + DEP
Recovery of NOWC
Project CFs
NPV
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
t=0
−$75,000
−$15,000
t=1
t=2
t=3
−$90,000
$75,000
25,000
25,000
$25,000
8,750
$16,250
25,000
$41,250
$75,000
25,000
25,000
$25,000
8,750
$16,250
25,000
$41,250
−$90,000
$41,250
$41,250
$75,000
25,000
25,000
$25,000
8,750
$16,250
25,000
$41,250
15,000
$56,250
$23,852
1
CHALLENGING
13-2 Analysis of an Expansion Project
Project NPV
Bloom's: Analysis
Multiple Choice: Problem
80. Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life
and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value
at the end of Year 3, when the project would be closed down. Also, additional net operating working capital would be
required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be
constant over the project's 3-year life. What is the project's NPV?
WACC
10.0%
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
Net investment in fixed assets (depreciable basis)
Required net operating working capital
Straight-line depreciation rate
Annual sales revenues
Annual operating costs (excl. depreciation)
Expected pre-tax salvage value
Tax rate
a. $20,762
b. $21,854
c. $23,005
d. $24,155
e. $25,363
ANSWER:
c
RATIONALE:
Investment in fixed assets
WACC = 10%
Investment in NOWC
Sales revenues
− Operating costs (excl. deprec.)
Depreciation
Rate = 33.333%
Operating income (EBIT)
Rate = 35%
− Taxes
EBIT(1 − T)
+ Depreciation
EBIT(1 − T) + DEP
Recovery of NOWC
Salvage value, pre-tax
Rate = 35%
− Tax on salvage value
Project CFs
NPV
POINTS:
DIFFICULTY:
REFERENCES:
TOPICS:
KEYWORDS:
OTHER:
$70,000
$10,000
33.333%
$75,000
$30,000
$5,000
35.0%
t=0
t=1
t=2
t=3
−$70,000
−10,000
$75,000
$75,000
$75,000
−30,000
−30,000
−30,000
−$80,000
−23,333
$21,667
7,583
$14,083
23,333
$37,417
−23,333
$21,667
7,583
$14,083
23,333
$37,417
−$80,000
$37,417
$37,417
−23,333
$21,667
7,583
$14,083
23,333
$37,417
10,000
5,000
1,750
$50,667
$23,005
1
CHALLENGING
13-2 Analysis of an Expansion Project
Project NPV
Bloom's: Analysis
Multiple Choice: Problem
81. Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year
tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value
after Year 3. No change in net operating working capital would be required. Revenues and other operating costs will be
constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset
profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the
project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)
WACC
Net investment cost (depreciable basis)
Number of cars washed
Average price per car
10.0%
$60,000
2,800
$25.00
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
Fixed oper. costs (excl. depreciation)
Variable oper. cost/unit (i.e., VC per car washed)
Annual depreciation
Tax rate
a. −$28,939
$10,000
$5.375
$20,000
35.0%
b. −$30,462
c. −$32,066
d. −$33,753
e. −$35,530
ANSWER:
e
RATIONALE: Base Case Calculations
Investment cost
Cars washed
Price per car
Variable cost/unit
WACC: 10%
2,800
$25.00
$5.375
Sales revenues
− Fixed op. cost (excl. deprec.)
− Variable op costs
− Depreciation
Operating income (EBIT)
− Taxes
EBIT(1 − T)
+ Depreciation
Project CFs
t=0
−$60,000
$10,000
$5.375
Rate = 33.333%
Rate = 35%
−$60,000
Base-Case NPV
t=1
t=2
t=3
2,800
$25.00
$5.375
2,800
$25.00
$5.375
2,800
$25.00
$5.375
$70,000
10,000
15,050
20,000
$24,950
8,733
$16,218
20,000
$36,218
$70,000
10,000
15,050
20,000
$24,950
8,733
$16,218
20,000
$36,218
$70,000
10,000
15,050
20,000
$24,950
8,733
$16,218
20,000
$36,218
t=1
t=2
t=3
1,680
$25
$5.375
1,680
$25
$5.375
1,680
$25
$5.375
$42,000
10,000
9,030
20,000
$ 2,970
1,040
$ 1,931
20,000
$21,931
$42,000
10,000
9,030
20,000
$ 2,970
1,040
$ 1,931
20,000
$21,931
$42,000
10,000
9,030
20,000
$ 2,970
1,040
$ 1,931
20,000
$21,931
$30,068
Bad Case Calculations
Investment cost
Cars washed
Price per car
Variable cost/unit
t=0
−$60,000
Declines by: 40%
Sales revenues
− Fixed op. cost (excl. deprec.)
− Variable op costs
− Depreciation
Operating income (EBIT)
− Taxes
EBIT(1 − T)
+ Depreciation
Project CFs
Bad-Case NPV
Change in NPV
−$60,000
−$5,462
−$35,530
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CHAPTER 13—CASH FLOW ESTIMATION AND RISK ANALYSIS
POINTS:
DIFFICULTY:
REFERENCES
:
TOPICS:
KEYWORDS:
OTHER:
1
CHALLENGING
13-5 Measuring Stand-Alone Risk
Sensitivity analysis
Bloom's: Evaluation
Multiple Choice: Problem
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