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To increase productive capacity, a company is considering a proposed new plant.Which of the following statements is CORRECT?


A) Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
B) 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.
C) Capital budgeting decisions should be based on before-tax cash flows.
D) The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.
E) 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.

F) All of the above
G) A) and B)

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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

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Which of the following statements is CORRECT?


A) 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.
B) 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.
C) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) 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.

F) None of the above
G) All of the above

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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

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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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Which of the following rules is CORRECT for capital budgeting analysis?


A) Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
B) 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.
C) 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.
D) 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.
E) The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

F) C) and E)
G) D) and E)

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Puckett Inc.risk-adjusts its WACC to account for project risk.It 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 Puckett accept, assuming that the company uses the NPV method when choosing projects?


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

F) None of the above
G) B) and D)

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Which of the following procedures best accounts for the relative risk of a proposed project?


A) Adjusting the discount rate downward if the project is judged to have above-average risk.
B) Reducing the NPV by 10% for risky projects.
C) Picking a risk factor equal to the average discount rate.
D) Ignoring risk because project risk cannot be measured accurately.
E) Adjusting the discount rate upward if the project is judged to have above-average risk.

F) A) and C)
G) A) and E)

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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

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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

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Sylvester Media 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.This is just one of many projects for the firm, so any losses 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 adjustment is required.What is the difference in the expected NPV if the inflation adjustment is made vs.if it is not made? Sylvester Media 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.This is just one of many projects for the firm, so any losses 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 adjustment is required.What is the difference in the expected NPV if the inflation adjustment is made vs.if it is not made? A) $13, 286 B) $13, 985 C) $14, 721 D) $15, 457 E) $16, 230


A) $13, 286
B) $13, 985
C) $14, 721
D) $15, 457
E) $16, 230

F) None of the above
G) A) and C)

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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

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Sheridan Films 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, some new 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? Sheridan Films 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, some new 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? A) $20, 762 B) $21, 854 C) $23, 005 D) $24, 155 E) $25, 363


A) $20, 762
B) $21, 854
C) $23, 005
D) $24, 155
E) $25, 363

F) A) and B)
G) B) and E)

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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

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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.

A) True
B) False

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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?


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 investment in 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.

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

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Century Roofing is thinking of opening a new warehouse, 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 warehouse.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 new 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.) Century Roofing is thinking of opening a new warehouse, 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 warehouse.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 new 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.) A) $10, 521 B) $11, 075 C) $11, 658 D) $12, 271 E) $12, 885


A) $10, 521
B) $11, 075
C) $11, 658
D) $12, 271
E) $12, 885

F) A) and D)
G) B) and E)

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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 customers.Thus, cannibalization is dealt with by society through the antitrust laws.
B) 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.
C) 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.
D) 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.
E) 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.

F) B) and D)
G) B) and E)

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