Exam 12: Cash Flow and Risk

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A) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.
B) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.
C) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
D) If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
E) If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

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

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

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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) $ 569.97
B) $ 782.34
C) $ 865.31
D) $1,522.18
E) $1,846.54

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A) Project A, which has average risk and an IRR = 9%.
B) Project B, which has below-average risk and an IRR = 8.5%.
C) Project C, which has above-average risk and an IRR = 11%.
D) 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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A) A shift from straight-line to MACRS depreciation.
B) Making the initial investment in the first year rather than spreading it over the first three years.
C) An increase in the discount rate associated with the project.
D) An increase in required net operating working capital.
E) The project would decrease sales of another product line.

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A) $56.50
B) $62.15
C) $68.37
D) $75.21
E) $82.73

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

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A) Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project.
B) If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
C) This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
D) Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
E) If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

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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.

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