CHAPTER 12 – Practice Problems
CASH FLOW ESTIMATION AND RISK ANALYSIS
(12-1) Cash flow estimation
1.
F I K
Answer: b
EASY
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
(12-1) Relevant cash flows
2.
Answer: b
EASY
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
(12-1) Relevant cash flows
3.
F I K
F I K
Answer: a
EASY
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
(12-2) Depreciation cash flows
4.
F I K
Answer: a
EASY
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
(12-1) Opportunity costs
5.
Answer: a
MEDIUM
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
(12-1) Sunk costs
6.
F I
F I
Answer: b
MEDIUM
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
(12-1) Cash flow issues
7.
C I
Answer: c
EASY/MEDIUM
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 PV.
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.
(12-2) Depreciation
C I
Answer: a
EASY/MEDIUM
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 straightline 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.
(12-1) Relevant cash flows
10.
EASY
Changes in net working capital.
Shipping and installation costs.
Cannibalization effects.
Opportunity costs.
Sunk costs that have been expensed for tax purposes.
(12-1) Sunk costs
9.
Answer: e
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.
b.
c.
d.
e.
8.
C I K
C I K
Answer: c
MEDIUM
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 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.
(12-1) Relevant cash flows
11.
MEDIUM
C I
Answer: b
MEDIUM
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.
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.
(12-2) Annual CF
13.
Answer: b
When evaluating a new project, firms should include in the projected
cash flows all of the following EXCEPT:
a. Changes in net 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.
(12-1) Externalities
12.
C I K
C I K
Answer: a
EASY
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
$13,000
Depreciation
$4,000
Other operating costs
$6,000
Tax rate
35.0%
a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568
(12-2) Annual CF
C I K
Answer: d EASY
14.
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)
$65,000
Straight-line depreciation rate
33.333%
Sales revenues, each year
$60,000
Operating costs (excl. deprec.)
$25,000
Tax rate
35.0%
a. $28,115
b. $28,836
c. $29,575
d. $30,333
e. $31,092
(12-2) Project NPV
C I K
Answer: e MEDIUM
15.
Temple Corp. is considering a new project whose data are shown below.
The equipment that would be used has a 3-year tax life, would be
depreciated by the straight-line method over its 3-year life, and would
have a zero salvage value. No new 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?
a.
b.
c.
d.
e.
Risk-adjusted WACC
Net investment cost (depreciable basis)
Straight-line deprec. rate
Sales revenues, each year
Operating costs (excl. deprec.), each year
Tax rate
$15,740
$16,569
$17,441
$18,359
$19,325
10.0%
$65,000
33.3333%
$65,500
$25,000
35.0%
(12-2) Salvage value
C I
Answer: e MEDIUM
16.
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 following rates. 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
Depreciation Rate
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
a. $8,878
b. $9,345
c. $9,837
d. $10,355
e. $10,900
(12-2) Project NPV
17.
C I K
Answer: a
HARD
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 some additional 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 are constant in Years 1 to 3.)
WACC
Net investment in fixed assets (basis)
Required new working capital
Straight-line deprec. rate
Sales revenues, each year
Operating costs (excl. deprec.), each year
Tax rate
a.
b.
c.
d.
e.
10.0%
$75,000
$15,000
33.333%
$75,000
$25,000
35.0%
$23,852
$25,045
$26,297
$27,612
$28,993
Solutions to Problem 17
7.
(12-2) Project NPV
Investment in fixed assets WACC = 10%
Investment in net working capital
Sales revenues
- Operating costs (excl. deprec.)
Depreciation
Rate = 33.333%
Operating income (EBIT)
- Taxes
Rate = 35%
After-tax EBIT
+ Depreciation
Cash flow from operations
Recovery of working capital
Total cash flows
NPV
$23,852
C I K
Answer: a
t=0
-$75,000
-$15,000
t=1
t=2
-$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
HARD
t=3
$75,000
25,000
25,000
$25,000
8,750
$16,250
25,000
$41,250
15,000
$56,250