BH FFM13 TB ch12 - testbank PDF

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CASH FLOW ESTIMATION CHAPTERAND 12 RISK ANALYSIS

(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines. Multiple Choice: True/False (12-1) Cash flow estimation 1

.

F I K

Answer: b

EASY

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

(12-1) Cash flow estimation 2

.

F I K

Answer: a

EASY

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

(12-1) Cash flow estimation 3

.

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 4

.

F I K

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 5

.

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

Chapter 12: Cash Flow and Risk

True/False

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b. False

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True/False

Chapter 12: Cash Flow and Risk

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(12-1) Relevant cash flows 6

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F I K

Answer: b

EASY

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

(12-1) Relevant cash flows 7

.

F I K

Answer: a

EASY

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

(12-1) Externalities 8

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F I

Answer: b

EASY

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

(12-1) Externalities 9

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F I

Answer: a

EASY

In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's longrun cash flows. a. True b. False

(12-1) Externalities 10

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F I

Answer: b

EASY

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

(12-2) Changes in NOWC 11

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F I

Answer: b

EASY

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

Chapter 12: Cash Flow and Risk

True/False

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(12-2) Depreciation cash flows 12

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F I K

Answer: b

EASY

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

(12-2) Depreciation cash flows 13

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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

(12-2) Depreciation cash flows 14

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F I K

Answer: b

EASY

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

(12-2) Depreciation cash flows 15

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F I K

Answer: a

EASY

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

(12-2) Depreciation cash flows 16

.

F I K

Answer: a

EASY

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

(12-4) Risk-adjusted discount rate 17

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F I

Answer: a

EASY

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

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True/False

Chapter 12: Cash Flow and Risk

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b. False (12-1) Cash flow estimation 18

.

F I K

Answer: b

MEDIUM

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

(12-1) Cash flow estimation 19

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F I K

Answer: a

MEDIUM

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

(12-1) Relevant cash flows 20

.

F I K

Answer: b

MEDIUM

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

(12-1) Opportunity costs 21

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F I

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 22

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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

(12-2) NOWC 23

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F I

Answer: b

MEDIUM

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

Chapter 12: Cash Flow and Risk

True/False

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b. False

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True/False

Chapter 12: Cash Flow and Risk

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(12-2) Depreciation cash flows 24

.

F I K

Answer: b

MEDIUM

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

(12-5) Sensitivity analysis 25

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F I

Answer: a

MEDIUM

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

(12-7) Replacement chain 26

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F I

Answer: b

MEDIUM

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

(12-7) Replacement chain 27

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F I

Answer: b

MEDIUM

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires. a. True b. False

(12-7) Common-life comparisons 28

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F I

Answer: a

MEDIUM

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

(12-7) Common life and EAA 29

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F I

Answer: a

MEDIUM

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

Chapter 12: Cash Flow and Risk

True/False

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(12-7) Common life and EAA 30

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F I

Answer: b

MEDIUM

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

Multiple Choice: Conceptual (12-1) Cash flow issues 31

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C I K

Changes in net operating working capital. Shipping and installation costs for machinery acquired. Cannibalization effects. Opportunity costs. Sunk costs that have been expensed for tax purposes.

(12-4) Risk adjustment .

EASY

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.

32

Answer: e

C I

Answer: a

EASY

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. 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.

(12-4) Risk and project selection 33

.

Suppose Tapley Inc. uses a WACC of 10% for average-risk projects, and Which of the following independent assuming that the company uses the

C I

Answer: b

EASY

8% for below-average risk projects, 12% for above-average risk projects. projects should Tapley accept, NPV method when choosing projects?

a. b. c. d.

Project A, which has average risk and an IRR = 9%. Project B, which has below-average risk and an IRR = 8.5%. Project C, which has above-average risk and an IRR = 11%. 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.

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Conceptual M/C

Chapter 12: Cash Flow and Risk

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(12-1) Sunk costs 34

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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 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.

(12-1) Sunk costs 35

.

C I

Answer: d

EASY/MEDIUM

Which of the following statements is CORRECT? 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.

(12-1) Externalities 36

.

C I

Answer: b

EASY/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 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.

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Conceptual M/C

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(12-1) Externalities 37

.

C I

Answer: b

EASY/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 sit...