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Exam 11: Cash Flow Estimation and Risk Analysis

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Question 1

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Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk.However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

A) True
B) False

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Question 2

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Which of the following statements is CORRECT?

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

F) A) and B)
G) C) and D)

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Question 3

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The two cardinal rules that financial analysts should follow to avoid capital budgeting 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.

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

You have just landed an internship in the CFO's office of Hawkesworth Inc.Your first task is to estimate the Year 1 cash flow for a project with the following data.What is the Year 1 cash flow? $\begin{array}{lr}\text { Sales revenues } & \$ 13,000 \\\text { Depreciation } & \$ 4,000 \\\text { Other operating costs } & \$ 6,000 \\\text { Tax rate } & 25.0 \%\end{array}$

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.

Weston Clothing Company is considering manufacturing a new style of shirt, 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 new 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 Weston's 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.) $\begin{array}{lr}\text { Cost of capital } & 10.0 \% \\\text { Pre-tax cash flow reduction for other products (cannibalization) } & \$ 5,000 \\\text { Investment cost (depreciable basis) } & \$ 80,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year for 3 years } & \$ 67,500 \\\text { Annual operating costs (excl. deprec) } & \$ 25,000 \\\text { Tax rate } & 25.0 \%\end{array}$

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.

McPherson Company must purchase a new milling machine.The purchase price is $50,000, including installation.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 25%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? $\begin{array} { c c } \text { Year } & \text { Depreciation Rate } \\1 & 0.20 \\2 & 0.32 \\3 & 0.19 \\4 & 0.12 \\5 & 0.11 \\6 & 0.06\end{array}$

McLeod Inc.is considering an investment that has an expected return of 15% and a standard deviation of 10%.What is the investment's coefficient of variation?

Wansley Enterprises is considering a new project.The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy.The company estimates that the 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?

Garden-Grow Products 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.) $\begin{array}{lr}\text { Proj ect cost of capital (r) } & 10.0 \% \\\text { Net investment in fixed assets (basis) } & \$ 75,000 \\\text { Required new working capital } & \$ 15,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sal es revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 25,000 \\\text { Tax rate } & 25.0 \%\end{array}$

In your first job with TBL Inc.your task is to consider a new project whose data are shown below.What is the project's Year 1 cash flow? $\begin{array} { l r } \text { Sales revenues } & \$ 22,250 \\\text { Depreciation } & \$ 8,000 \\\text { Other operating costs } & \$ 12,000 \\\text { Tax rate } & 25.0 \%\end{array}$

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.

While developing a new product line, Cook 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.Cook owns the building free and clear⎯there is no mortgage on it.Which of the following statements is CORRECT?

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

The CFO of Cicero Industries plans to calculate a new 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 flow) , 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?

Which of the following statements is CORRECT?

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.

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.