Exam 12: Cash Flow and Risk

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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.

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A) $5,950
B) $6,099
C) $6,251
D) $6,407
E) $6,568

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A

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.

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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.

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

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A) $23,852
B) $25,045
C) $26,297
D) $27,612
E) $28,993

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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 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.
Multiple Choice: 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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D

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.

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A) $ 8,878
B) $ 9,345
C) $ 9,837
D) $10,355
E) $10,900

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E

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.

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