Answer Options:
a. True
b. False
Answer: B. False
Question: Dalyrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
Answer Options:
a. The firm’s existing debt on its balance sheet is a relevant factor.
b. The company would issue new equity to finance the new project.
c. Some of the equipment to be used in the new project is currently being used in another part of the company, and if it were used in the new project, the company would have to replace it at a cost of $1 million.
d. A new machine that is needed for the project would have to be purchased, and this machine would have a salvage value at the end of the project’s life.
e. None of these items should be included; they are all sunk costs and, therefore, should not affect the estimated cash flows.
Answer: A. The firm’s existing debt on its balance sheet is a relevant factor.
Question: Which of the following statements is CORRECT?
Answer Options:
a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.
c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Answer: E. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Question: Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer Options:
a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
Answer: D. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
Question: When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer Options:
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.
Answer: B. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
Question: An increase in the firm’s WACC will decrease projects’ NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects’ IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.
Answer Options:
a. True
b. False
Answer: True
Question: 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,” but 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, and to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.
Answer Options:
a. True
b. False
Answer: B. False
Question: 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.
Answer Options:
a. True
b. False
Answer: A. True
Question: Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has.
Answer Options:
a. True
b. False
Answer: a. True
Question: Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?
Answer Options:
a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
Answer: D. The firm will accept too few projects in all economic states because a 4-year payback is too high.
Question: A company is considering a new project. The CFO plans to calculate the 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 flows), 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?
Answer Options:
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 additional investment in net operating 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.
Answer: C. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
Answer: A. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
Question: 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.
Answer Options:
a. True
b. False
Answer: A. True
Question: Real options are most valuable when the underlying source of risk—such as uncertainty about unit sales, or the sales price, or input costs—is very low.
Answer Options:
a. True
b. False
Answer: B. False
Question: The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer Options:
a. If Project A has a higher IRR than Project B, then Project A must have the lower NPV.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
Answer: B. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
Answer: A. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
Question: 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.
Answer Options:
a. True
b. False
Answer: B. False