CASH FLOW ESTIMATION AND RISK ANALYSIS EXERCISE

CASH FLOW ESTIMATION CHAPTERAND 13 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 (13-1) 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

(13-1) 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

(13-1) 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

(13-1) 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

(13-1) 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 13: Cash Flow and Risk

True/False

Page 181

© 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.

b. False

Page 182

True/False

Chapter 13: 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.

(13-1) Relevant cash flows 6

.

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

(13-1) 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

(13-1) Externalities 8

.

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

(13-1) Externalities 9

.

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

(13-1) Externalities 10

.

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

(13-2) Changes in NOWC 11

.

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 13: Cash Flow and Risk

True/False

Page 183

© 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.

(13-2) Depreciation cash flows 12

.

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

(13-2) Depreciation cash flows 13

.

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

(13-2) Depreciation cash flows 14

.

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

(13-2) Depreciation cash flows 15

.

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

(13-2) 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

(13-4) Risk-adjusted discount rate 17

.

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

Page 184

True/False

Chapter 13: 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.

b. False (13-1) 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

(13-1) Cash flow estimation 19

.

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

(13-1) 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

(13-1) Opportunity costs 21

.

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

(13-1) Sunk costs 22

.

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

(13-2) NOWC 23

.

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 13: Cash Flow and Risk

True/False

Page 185

© 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.

b. False

Page 186

True/False

Chapter 13: 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.

(13-2) 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

(13-5) Sensitivity analysis 25

.

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

(13-7) Replacement chain 26

.

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

(13-7) Replacement chain 27

.

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

(13-7) Common-life comparisons 28

.

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

(13-7) Common life and EAA 29

.

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 13: Cash Flow and Risk

True/False

Page 187

© 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.

(13-7) Common life and EAA 30

.

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 (13-1) Cash flow issues 31

.

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.

(13-4) 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.

(13-4) 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.

Page 188

Conceptual M/C

Chapter 13: 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.

(13-1) Sunk costs 34

.

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.

(13-1) 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.

(13-1) 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.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 189

© 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.

(13-1) 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 situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase. 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.

(13-1) Externalities 38

.

C I

Answer: e

EASY/MEDIUM

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 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.

(13-2) Depreciation 39

.

C I

Answer: a

EASY/MEDIUM

Which of the following statements is CORRECT? 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 straightline 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.

Page 190

Conceptual M/C

Chapter 13: 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.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 191

© 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.

(13-2) Depreciation 40

.

C I

Answer: d

EASY/MEDIUM

Which of the following statements is CORRECT? a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset. b. Under current laws and regulations, corporations must use straightline depreciation for all assets whose lives are 5 years or longer. c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV. e. Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project’s forecasted NPV.

(13-2) Depreciation 41

.

C I

Answer: e

EASY/MEDIUM

Which of the following statements is CORRECT? 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 straightline 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.

(13-1) Relevant cash flows 42

.

C I K

Answer: c

MEDIUM

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? 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.

Page 192

Conceptual M/C

Chapter 13: 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.

e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 193

© 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.

(13-1) Relevant cash flows 43

.

C I K

Answer: c

MEDIUM

Which of the following factors should be included in the cash flows used to estimate a project’s NPV? a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted. b. Interest on funds borrowed to help finance the project. c. The end-of-project recovery of any additional net operating working capital required to operate the project. d. Cannibalization effects, but only if those effects increase the project’s projected cash flows. e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

(13-1) Relevant cash flows 44

.

C I K

Answer: b

MEDIUM

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: 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.

(13-1) Relevant cash flows 45

.

C I K

Answer: b

MEDIUM

Rowell 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. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT? 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.

Page 194

Conceptual M/C

Chapter 13: 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.

(13-1) Relevant cash flows 46

.

C I K

Answer: a

MEDIUM

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. The new project is expected to reduce sales of one of the company’s existing products by 5%. b. Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost. c. The company has spent and expensed $1 million on research and development costs associated with the new project. d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

(13-1) Relevant cash flows 47

.

C I K

Answer: c

MEDIUM

Dalrymple 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? a. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products. b. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. c. The company has spent and expensed for tax purposes $3 million on research related to the new product. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. d. The new product will cut into sales of some of the firm’s other products. e. If the project is accepted, the company must invest an additional $2 million in net operating working capital. However, all of these funds will be recovered at the end of the project’s life.

(13-1) Relevant cash flows 48

.

C I K

Answer: b

MEDIUM

Which of the following rules is CORRECT for capital budgeting analysis? a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows. b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects. c. 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. d. 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.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 195

© 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.

e. 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. (13-1) Relevant cash flows C I K Answer: d MEDIUM 49

.

Which of the following statements is CORRECT? 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.

(13-1) Incremental cash flows 50

.

C I K

Answer: d

MEDIUM

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? 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.

Page 196

Conceptual M/C

Chapter 13: 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.

(13-1) Incremental cash flows 51

.

C I K

Answer: d

MEDIUM

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? a. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration. b. Revenues from an existing product would be lost as a result of customers switching to the new product. c. Shipping and installation costs associated with a machine that would be used to produce the new product. d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

(13-2) New project cash flows 52

.

C I K

Answer: a

MEDIUM

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? 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.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 197

© 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.

(13-4) Risk analysis 53

.

C I

Answer: c

MEDIUM

Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X $350,000 $100,000 1.4 Cash flows are not correlated with the cash flows from existing projects

Expected NPV Standard deviation (σNPV) Project beta (vs. market) Correlation of the project cash flows with cash flows from currently existing projects

Project Y $350,000 $150,000 0.8 Cash flows are highly correlated with the cash flows from existing projects

Which of the following statements is CORRECT? a. b. c. d. e.

Project Project Project Project Project are not

X has more stand-alone risk than Project Y. X has more corporate (or within-firm) risk than Project Y. X has more market risk than Project Y. X has the same level of corporate risk as Project Y. X has the same market risk as Project Y since its cash flows correlated with the cash flows of existing projects.

(13-4) Risk analysis 54

.

C I

would have more stand-alone risk than the would would would would

(13-4) Project's effect on firm risk .

MEDIUM

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a 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? a. The proposed new project firm’s typical project. b. The proposed new project c. The proposed new project d. The proposed new project e. The proposed new project firm’s typical project.

55

Answer: a

increase the firm’s corporate risk. increase the firm’s market risk. not affect the firm’s risk at all. have less stand-alone risk than the C I

Answer: e

MEDIUM

A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated IRR of the project to reflect its greater risk. b. Increase the estimated NPV of the project to reflect its greater risk. c. Reject the project, since its acceptance would increase the firm’s risk.

Page 198

Conceptual M/C

Chapter 13: 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.

d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets. e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. (13-5) Risk techniques 56

.

C I

Answer: e

MEDIUM

Which of the following statements is CORRECT? 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.

(13-5) Risk techniques 57

.

C I

Answer: a

MEDIUM

Which of the following statements is CORRECT? a. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV. c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. e. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

Chapter 13: Cash Flow and Risk

Conceptual M/C

Page 199

© 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.

(Comp.) CFs and accounting measures 58

.

C I K

Answer: d

MEDIUM

Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the project’s completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a project’s life. d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.

Multiple Choice: Problems We designated many of these questions EASY or MEDIUM. This indicates that they are not conceptually hard. However, some of them require a good bit of arithmetic, which will lengthen the time it takes students to work them. We tried to use constant cash flows, straight-line depreciation (except where we wanted to illustrate accelerated depreciation), and short project lives, but completing the cash flow estimation process still requires a good bit of arithmetic. This should not be important for take-home tests, but it should be considered when making up timed tests. (13-2) Annual CF 59

.

C I K

Answer: a

EASY

As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow? Sales revenues Depreciation Other operating costs Tax rate a. b. c. d. e.

Page 200

$13,000 $4,000 $6,000 35.0%

$5,950 $6,099 $6,251 $6,407 $6,568

M/C Problems

Chapter 13: 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.

(13-2) Annual CF 60

.

C I K

a. b. c. d. e.

$22,250 $8,000 $12,000 35.0%

$ 8,903 $ 9,179 $ 9,463 $ 9,746 $10,039

(13-2) Annual CF .

C I K

a. b. c. d. e.

EASY

$65,000 33.333% $60,000 $25,000 35.0%

$28,115 $28,836 $29,575 $30,333 $31,092

(13-2) Annual CF .

Answer: d

Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow? Equipment cost (depreciable basis) Straight-line depreciation rate Sales revenues, each year Operating costs (excl. depreciation) Tax rate

62

EASY

Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow? Sales revenues Depreciation Other operating costs Tax rate

61

Answer: c

C I K

Answer: e

EASY/MEDIUM

As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow? Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate a. b. c. d. e.

$42,500 $10,000 $17,000 $4,000 35.0%

$16,351 $17,212 $18,118 $19,071 $20,075

Chapter 13: Cash Flow and Risk

M/C Problems

Page 201

© 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.

(13-2) Annual CF 63

.

C I K

a. b. c. d. e.

$62,500 $8,000 $25,000 $8,000 35.0%

$25,816 $27,175 $28,534 $29,960 $31,458

(13-2) Annual CF; MACRS .

C I K

a. b. c. d. e.

EASY/MEDIUM

$65,000 $60,000 $25,000 35.0%

$30,258 $31,770 $33,359 $35,027 $36,778

(13-2) Annual CF; MACRS .

Answer: a

Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow? Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. depreciation) Tax rate

65

EASY/MEDIUM

You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow? Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate

64

Answer: b

C I K

Answer: c

MEDIUM

Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow? Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. depreciation) Tax rate a. b. c. d. e.

Page 202

$70,000 $42,500 $25,000 35.0%

$11,814 $12,436 $13,090 $13,745 $14,432 M/C Problems

Chapter 13: 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.

(13-2) Project NPV 66

.

C I K

Answer: e

MEDIUM

Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No change in net operating working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Risk-adjusted WACC Net investment cost (depreciable basis) Straight-line depreciation rate Sales revenues, each year Annual operating costs (excl. depreciation) Tax rate a. b. c. d. e.

$15,740 $16,569 $17,441 $18,359 $19,325

(13-2) Salvage value 67

.

C I

MEDIUM

$5,558 $5,850 $6,143 $6,450 $6,772

(13-2) Salvage value .

Answer: b

Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment’s after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale. a. b. c. d. e.

68

10.0% $65,000 33.3333% $65,500 $25,000 35.0%

C I

Answer: e

MEDIUM

Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the depreciation rates below. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? Year 1 2 3 4 5 6

Depreciation Rate 0.20 0.32 0.19 0.12 0.11 0.06

a. $ 8,878 b. $ 9,345 c. $ 9,837 Chapter 13: Cash Flow and Risk

M/C Problems

Page 203

© 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.

d. $10,355 e. $10,900

Page 204

M/C Problems

Chapter 13: 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.

(13-7) Replacement chain approach 69

.

Answer: d

MEDIUM

$1,345.50 $1,346.30 $1,361.52 $1,376.74 $1,411.15

(13-7) Equivalent annual annuity .

C I

Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual annuity of the most profitable project? a. b. c. d. e.

71

MEDIUM

$4,242 $4,246 $4,286 $4,325 $4,433

(13-7) Equivalent annual annuity .

Answer: d

Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,900 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project? a. b. c. d. e.

70

C I

C I

Answer: c

MEDIUM

Carlyle Inc. is considering two mutually exclusive projects. Both require an initial investment of $15,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2, respectively. In addition, Project S can be repeated at the end of Year 2 with no changes in its cash flows. Project L has an expected life of 4 years with after-tax cash inflows of $5,200 at the end of each of the next 4 years. Each project has a WACC of 9.00%. What is the equivalent annual annuity of the most profitable project? a. b. c. d. e.

$ 569.97 $ 782.34 $ 865.31 $1,522.18 $1,846.54

Chapter 13: Cash Flow and Risk

M/C Problems

Page 205

© 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.

(13-2) Project NPV 72

.

C I K

Answer: b

TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straightline method over its 3-year life and would have a zero salvage value, and no change in net operating 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 TexMex 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.) WACC Pre-tax cash flow reduction for other products (cannibalization) Investment cost (depreciable basis) Straight-line depreciation rate Annual sales revenues Annual operating costs (excl. depreciation) Tax rate a. b. c. d. e.

.

10.0% -$5,000 $80,000 33.333% $67,500 -$25,000 35.0%

$3,636 $3,828 $4,019 $4,220 $4,431

(13-2) Project NPV 73

MEDIUM/HARD

C I K

Answer: d

MEDIUM/HARD

Sub-Prime Loan Company is thinking of opening a new office, 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 office. 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 change in net operating 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.) WACC Opportunity cost Net equipment cost (depreciable basis) Straight-line depreciation rate for equipment Annual sales revenues Annual operating costs (excl. depreciation) Tax rate a. b. c. d. e.

Page 206

10.0% $100,000 $65,000 33.333% $123,000 $25,000 35%

$10,521 $11,075 $11,658 $12,271 $12,885

M/C Problems

Chapter 13: 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.

(13-7) Replacement chain approach 74

.

MEDIUM/HARD

$56.50 $62.15 $68.37 $75.21 $82.73

(13-2) NPV including inflation .

Answer: a

Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next 4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. The controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is selected over Project S, i.e., what is the value of NPVL - NPVS? a. b. c. d. e.

75

C I

C I K

Answer: c

HARD

Desai Industries 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. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? WACC Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed oper. costs excl. depreciation (constant) Variable oper. cost/unit, Year 1 Annual depreciation rate Expected inflation rate per year Tax rate a. b. c. d. e.

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 5.00% 40.0%

$15,925 $16,764 $17,646 $18,528 $19,455

Chapter 13: Cash Flow and Risk

M/C Problems

Page 207

© 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.

(13-2) NPV including inflation 76

.

C I K

Answer: c

Poulsen Industries 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. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project 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 inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made? WACC Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed oper. costs excl. depreciation (constant) Variable oper. cost/unit, Year 1 Annual depreciation rate Expected inflation Tax rate a. b. c. d. e.

.

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 4.00% 40.0%

$12,018 $12,650 $13,316 $13,982 $14,681

(13-2) Project NPV 77

HARD

C I K

Answer: a

HARD

Foley Systems 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 additional net operating 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 from operations are constant in Years 1 to 3.) WACC Net investment in fixed assets (basis) Required net operating working capital Straight-line depreciation rate Annual sales revenues Annual operating costs (excl. depreciation) Tax rate a. b. c. d. e.

Page 208

10.0% $75,000 $15,000 33.333% $75,000 $25,000 35.0%

$23,852 $25,045 $26,297 $27,612 $28,993 M/C Problems

Chapter 13: 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.

(13-2) Project NPV 78

.

C I K

a. b. c. d. e.

10.0% $70,000 $10,000 33.333% $75,000 $30,000 $5,000 35.0%

$20,762 $21,854 $23,005 $24,155 $25,363

(13-5) Sensitivity analysis .

HARD

Thomson Media 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, additional net operating 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? WACC Net investment in fixed assets (depreciable basis) Required net operating working capital Straight-line depreciation rate Annual sales revenues Annual operating costs (excl. depreciation) Expected pre-tax salvage value Tax rate

79

Answer: c

C I K

Answer: e

HARD

Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No change in net operating working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) WACC Net investment cost (depreciable basis) Number of cars washed Average price per car Fixed oper. costs (excl. depreciation) Variable oper. cost/unit (i.e., VC per car washed) Annual depreciation Tax rate a. b. c. d. e.

10.0% $60,000 2,800 $25.00 $10,000 $5.375 $20,000 35.0%

-$28,939 -$30,462 -$32,066 -$33,753 -$35,530

Chapter 13: Cash Flow and Risk

M/C Problems

Page 209

© 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.

TAX DEPRECIATION APPENDIX 13A (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: Conceptual (13A) NPV and depreciation 80

.

C I

Answer: a

EASY/MEDIUM

Other things held constant, which of the following would increase the NPV of a project being considered? 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.

(13A) Depreciation cash flows 81

.

C I

Answer: c

MEDIUM

Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce a. Higher depreciation charges in the early years of an asset’s life. b. Larger cash flows in the earlier years of an asset’s life. c. Larger total undiscounted profits from the project over the project’s life. d. Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes. e. Lower tax payments in the earlier years of an asset’s life.

Page 210

Conceptual M/C Appendix 9A: Stock Market Equilibrium

ANSWERS AND SOLUTIONS CHAPTER 13

Chapter 13: Cash Flow and Risk

Answers

Page 211

© 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.

1.

(13-1) Cash flow estimation

F I K

Answer: b

EASY

2.

(13-1) Cash flow estimation

F I K

Answer: a

EASY

3.

(13-1) Cash flow estimation

F I K

Answer: b

EASY

4.

(13-1) Relevant cash flows

F I K

Answer: b

EASY

5.

(13-1) Relevant cash flows

F I K

Answer: a

EASY

6.

(13-1) Relevant cash flows

F I K

Answer: b

EASY

7.

(13-1) Relevant cash flows

F I K

Answer: a

EASY

8.

(13-1) Externalities

F I

Answer: b

EASY

9.

(13-1) Externalities

F I

Answer: a

EASY

10.

(13-1) Externalities

F I

Answer: b

EASY

If the externality is potentially important, it should not be ignored, because then a large error might be made. At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of its possible effects. 11.

(13-2) Changes in NOWC

F I

Answer: b

EASY

12.

(13-2) Depreciation cash flows

F I K

Answer: b

EASY

13.

(13-2) Depreciation cash flows

F I K

Answer: a

EASY

14.

(13-2) Depreciation cash flows

F I K

Answer: b

EASY

15.

(13-2) Depreciation cash flows

F I K

Answer: a

EASY

16.

(13-2) Depreciation cash flows

F I K

Answer: a

EASY

17.

(13-4) Risk-adjusted discount rate F I

Answer: a

EASY

18.

(13-1) Cash flow estimation

F I K

Answer: b

MEDIUM

19.

(13-1) Cash flow estimation

F I K

Answer: a

MEDIUM

20.

(13-1) Relevant cash flows

F I K

Answer: b

MEDIUM

21.

(13-1) Opportunity costs

F I

Answer: a

MEDIUM

22.

(13-1) Sunk costs

F I

Answer: b

MEDIUM

23.

(13-2) NOWC

F I

Answer: b

MEDIUM

24.

(13-2) Depreciation cash flows

F I K

Answer: b

MEDIUM

25.

(13-5) Sensitivity analysis

F I

Answer: a

MEDIUM

26.

(13-7) Replacement chain

F I

Answer: b

MEDIUM

27.

(13-7) Replacement chain

F I

Answer: b

MEDIUM

28.

(13-7) Common-life comparisons

F I

Answer: a

MEDIUM

29.

(13-7) Common life and EAA

F I

Answer: a

MEDIUM

30.

(13-7) Common life and EAA

F I

Answer: b

MEDIUM

31.

(13-1) Cash flow issues

C I K

Answer: e

EASY

32.

(13-4) Risk adjustment

C I

Answer: a

EASY

33.

(13-4) Risk and project selection C I

Answer: b

EASY

34.

(13-1) Sunk costs

C I

Answer: c

EASY/MEDIUM

35.

(13-1) Sunk costs

C I

Answer: d

EASY/MEDIUM

36.

(13-1) Externalities

C I

Answer: b

EASY/MEDIUM

37.

(13-1) Externalities

C I

Answer: b

EASY/MEDIUM

38.

(13-1) Externalities

C I

Answer: e

EASY/MEDIUM

39.

(13-2) Depreciation

C I

Answer: a

EASY/MEDIUM

40.

(13-2) Depreciation

C I

Answer: d

EASY/MEDIUM

41.

(13-2) Depreciation

C I

Answer: e

EASY/MEDIUM

42.

(13-1) Relevant cash flows

C I K

Answer: c

MEDIUM

43.

(13-1) Relevant cash flows

C I K

Answer: c

MEDIUM

44.

(13-1) Relevant cash flows

C I K

Answer: b

MEDIUM

45.

(13-1) Relevant cash flows

C I K

Answer: b

MEDIUM

46.

(13-1) Relevant cash flows

C I K

Answer: a

MEDIUM

47.

(13-1) Relevant cash flows

C I K

Answer: c

MEDIUM

48.

(13-1) Relevant cash flows

C I K

Answer: b

MEDIUM

49.

(13-1) Relevant cash flows

C I K

Answer: d

MEDIUM

Regarding a and b, note that since interest should not be considered, exclusion will not lead to any type of bias, positive or negative. 50.

(13-1) Incremental cash flows

C I K

Answer: d

MEDIUM

51.

(13-1) Incremental cash flows

C I K

Answer: d

MEDIUM

52.

(13-2) New project cash flows

C I K

Answer: a

MEDIUM

53.

(13-4) Risk analysis

C I

Answer: c

MEDIUM

Statement c is true, while the other statements are false. Stand-alone risk is measured by standard deviation. Therefore, since Y’s standard deviation is higher than X’s, Y has higher stand-alone risk than X. Statement b is false because corporate risk is affected by the correlation of project cash flows with other company cash flows, and since Y’s cash flows are more highly correlated with the cash flows of existing projects than X’s, Y has more corporate risk than X. Market risk is measured by beta. Therefore, since X’s beta is greater than Y’s, statement c is true.

54.

(13-4) Risk analysis

C I

Answer: a

MEDIUM

Statement a is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other firms' revenues; hence, its within-firm and market risks would be relatively low. 55.

(13-4) Project's effect on firm risk C I

Answer: e

MEDIUM

56.

(13-5) Risk techniques

C I

Answer: e

MEDIUM

57.

(13-5) Risk techniques

C I

Answer: a

MEDIUM

58.

(Comp.) CFs and accounting measures C I K

Answer: d

MEDIUM

59.

(12-2) Annual CF Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 1

60.

(13-2) Annual CF Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 1

61.

(13-2) Annual CF

C I K

Answer: a

EASY

Answer: c

EASY

Answer: d

EASY

$13,000 6,000 4,000 $ 3,000 1,050 $ 1,950 4,000 $ 5,950 C I K $22,250 12,000 8,000 $ 2,250 788 $ 1,463 8,000 $ 9,463

C I K

Equipment life, years Equipment cost Depreciation: rate = 33.333%

3 $65,000 $21,667

Sales revenues − Basis x rate = depreciation − Operating costs (excl. deprec.) Operating income (EBIT) − Taxes Rate = 35.0% EBIT(1 – T) + Depreciation

$60,000 21,667 25,000 $13,333 4,667 $ 8,667 21,667

Cash flow, Year 1 62.

(13-2) Annual CF

$30,333 C I K

Answer: e

EASY/MEDIUM

This problem is a bit harder than some of the earlier ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the calculation of cash flows since they will be discounted at the WACC in determining a project’s NPV. Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 1 63.

(13-2) Annual CF

$42,500 17,000 10,000 $15,500 5,425 $10,075 10,000 $20,075 C I K

Answer: b

EASY/MEDIUM

This problem is a bit harder than some of the earlier ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows. Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 1

64.

65.

(13-2) Annual CF; MACRS

$62,500 25,000 8,000 $29,500 10,325 $19,175 8,000 $27,175

C I K

Equipment cost Depreciation rate

$65,000 33.0%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 1

$60,000 25,000 21,450 $13,550 4,743 $ 8,808 21,450 $30,258

(13-2) Annual CF; MACRS

C I K

Answer: a

EASY/MEDIUM

Answer: c

MEDIUM

66.

Equipment cost Depreciation rate, Year 4

$70,000 7.0%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Cash flow, Year 4

$42,500 25,000 4,900 $12,600 4,410 $ 8,190 4,900 $13,090

(13-2) Project NPV

C I K

WACC 10.0% Years Investment cost Sales revenues − Operating costs (excl. deprec.) − Depreciation rate = 33.333% Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Project CFs NPV $19,325 67.

(13-2) Salvage value

0 -$65,000

-$65,000

(13-2) Salvage value

$65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

3 $65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

Answer: b

MEDIUM

Answer: e

MEDIUM

$22,500 16,875 $ 5,625 6,000 $ 375 -150 $ 5,850 C I

Deprec. Rate 0.20 0.32 0.19 0.12 0.11 0.06 1.00

Gross sales proceeds Book value, end of Year 4 Profit Tax on profit Rate = 40% AT salvage value = market value +/− taxes 69.

$65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

2

MEDIUM

75% 40%

Equipment cost − Accumulated deprec. Current book value of equipment Market value of equipment Gain (or loss): Market value − Book value Taxes paid on gain (−) or credited (+) on loss AT salvage value = market value +/− taxes

Year 1 2 3 4 5 6

1

C I

% depreciated on equip. Tax rate

68.

Answer: e

(13-7) Replacement chain approach

Basis $50,000 50,000 50,000 50,000 50,000 50,000

Annual Deprec. $10,000 16,000 9,500 6,000 5,500 3,000 $50,000

Year-end Book Value $40,000 24,000 14,500 8,500 3,000 0

$12,500 8,500 $ 4,000 1,600 $10,900 C I

Answer: d

MEDIUM

WACC = 8.00% Project X CFs Extended CFs Total Project X CFs

0 -10,000

1 6,000

3

4

6,000

2 7,900 -10,000 -2,100

-10,000

6,000 6,000

7,900 7,900

1 4,300

2 4,300

3 4,300

4 4,300

Project X, extended NPV = $4,324.87 Project Y CFs

0 -10,000

Project Y, NPV = $4,242.15 NPV of most profitable project, Project X = $4,324.87  $4,325.

70.

(13-7) Equivalent annual annuity

C I

Answer: d

WACC = 11.00% Project X CFs

0 -10,000

1 6,000

2 8,500

1 4,600

2 4,600

Project X, NPV = $2,304.20 Determine Project X EAA: N 2 I/YR 11.00% PV $2,304.20 FV 0 PMT = EAAX $1,345.50 Project Y CFs Project Y, NPV = $4,271.25 Determine Project Y EAA: N 4 I/YR 11.00% PV $4,271.25

0 -10,000

3 4,600

4 4,600

MEDIUM

FV PMT = EAAY

0 $1,376.74

EAA of most profitable project, Project Y = $1,376.74 71.

(13-7) Equivalent annual annuity WACC = 9.00% Project S: CFs

0 -$15,000

C I

Answer: c

1 $7,000

MEDIUM

2 $12,000

NPVS $1,522.18 EAAS: Enter the following inputs in your financial calculator: N = 2; I/YR = 9; PV = -1522.18; FV = 0; and solve for PMT = EAA = $865.31. Project L: CFs

0 -$15,000

1 $5,200

2 $5,200

3 $5,200

4 $5,200

NPVL $1,846.54 EAAL: Enter the following inputs in your financial calculator: N = 4; I/YR = 9; PV = -1846.54; FV = 0; and solve for PMT = EAA = $569.97. The most profitable project is the one with the higher EAA. Since EAA S > EAAL, choose Project S with EAA = $865.31.

72.

(13-2) Project NPV

C I K t=0 $80,000

Investment (Basis) WACC = 10% Sales revenues − Cannibalization cost − Operating costs (excl. deprec.) − Basis x rate = deprec. Rate = 33.33% Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Project CFs NPV $3,828 73.

(13-2) Project NPV Investment WACC = 10% Opportunity cost Revenues − Operating costs (excl. deprec.) − Basis x rate = deprec. Rate = 33.33% Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Project CFs

Answer: b

-$80,000 C I K t=0 -$ 65,000 -100,000

-$165,000

t=1 $67,500 -5,000 -25,000 -26,667 $10,833 -3,792 $ 7,042 26,667 $33,708

MEDIUM/HARD

t=2

t=3

$67,500 -5,000 -25,000 -26,667 $10,833 -3,792 $ 7,042 26,667 $33,708

Answer: d

$67,500 -5,000 -25,000 -26,667 $10,833 -3,792 $ 7,042 26,667 $33,708

MEDIUM/HARD

t=1

t=2

t=3

$123,000 -25,000 -21,667 $ 76,333 26,717 $49,617 21,667 $ 71,283

$123,000 -25,000 -21,667 $76,333 26,717 $49,617 21,667 $ 71,283

$123,000 -25,000 -21,667 $76,333 26,717 $49,617 21,667 $ 71,283

NPV 74.

$12,271

(13-7) Replacement chain approach WACC = 9.25% Project S: CFs Extended CFs Total CFs

C I

0 -$10,000

1 $6,000

-$10,000

0 -$10,000

Answer: a

MEDIUM/HARD

3

4

$6,000

2 $ 8,000 -10,000 -$ 2,000

$6,000 $6,000

$8,000 $8,000

1 $4,373

2 $4,373

3 $4,373

4 $4,373

NPVS = $4,033.40 Project L: CFs NPVL = $4,089.90 NPVL – NPVS = $56.50

75.

(13-2) NPV including inflation Base Case Calculations Investment cost WACC = 10% Inflation Price per unit VC per unit Units sold Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Rate = 33.333% Operating income (EBIT) − Taxes Rate = 40% EBIT(1 – T) + Depreciation Project CFs NPV $17,646

C I K t=0 -$200,000

Answer: c t=1

5.0% $25.00 $20.20 50,000 $1,250,000 150,000 1,010,000 66,667 $ 23,333 9,333 $ 14,000 66,667 -$200,000 $ 80,667

t=2 5.0% $26.25 $21.21 50,000 $1,312,500 150,000 1,060,500 66,667 $ 35,333 14,133 $ 21,200 66,667 $ 87,867

HARD

t=3 5.0% $27.56 $22.27 50,000 $1,378,125 150,000 1,113,525 66,667 $ 47,933 19,173 $ 28,760 66,667 $ 95,427

76.

(13-2) NPV including inflation

C I K

Answer: c

HARD

NPV with no adjustment Investment cost Inflation (set to 0%) Price per unit VC per unit Units sold

WACC = 10%

Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs per unit = $20.20 − Depreciation Rate = 33.3% Operating income (EBIT) − Taxes Rate = 40% EBIT(1 – T) + Depreciation Project CFs NPV w/o infl. adjustment -$6,556 NPV with adjustment Investment cost Inflation Price per unit VC per unit Units sold

WACC = 10%

Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs per unit = $20.20 − Depreciation Rate = 33.3%

t=0 -$200,000

t=1

t=2

t=3

0.0% $25.00 $20.20 49,000

0.0% $25.00 $20.20 49,000

0.0% $25.00 $20.20 49,000

$1,225,000 150,000 989,800 66,667 $ 18,533 7,413 $ 11,120 66,667 -$200,000 $ 77,787

$1,225,000 150,000 989,800 66,667 $ 18,533 7,413 $ 11,120 66,667 $ 77,787

$1,225,000 150,000 989,800 66,667 $ 18,533 7,413 $ 11,120 66,667 $ 77,787

t=0 -$200,000

t=1 4.0% $25.00 $20.20 49,000

t=2 4.0% $26.00 $21.01 49,000

t=3 4.0% $27.04 $21.85 49,000

$1,225,000 $1,274,000 $1,324,960 150,000 150,000 150,000 989,800 1,029,392 1,070,568 66,666 66,666 66,666

Operating income (EBIT) − Taxes Rate = 40% EBIT(1 – T) + Depreciation Project CFs NPV w/infl. adjustment $6,760 Increase w/infl. adjustment $13,316

77.

(13-2) Project NPV

$ $ -$200,000 $

C I K t=0 -$75,000 -$15,000

Investment in fixed assets WACC = 10% Investment in NOWC Sales revenues - Operating costs (excl. deprec.) Depreciation Rate = 33.333% Operating income (EBIT) - Taxes Rate = 35% EBIT(1 – T) + Depreciation EBIT(1 – T) + DEP Recovery of NOWC Project CFs NPV $23,852 78.

(13-2) Project NPV Investment in fixed assets WACC = 10% Investment in NOWC Sales revenues − Operating costs (excl. deprec.) Depreciation Rate = 33.333% Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation EBIT(1 – T) + DEP Recovery of NOWC Salvage value, pre-tax − Tax on salvage value Rate = 35% Project CFs NPV $23,005

18,534 $ 7,414 11,120 $ 66,666 77,786 $

t=1

27,942 $ 11,177 16,765 $ 66,666 83,431 $

37,726 15,091 22,636 66,666 89,302

Answer: a

HARD

t=2

-$90,000

$75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250

$75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250

-$90,000

$41,250

$41,250

C I K

t=3 $75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250 15,000 $56,250

Answer: c t=0 -$70,000 -10,000

t=1

t=2

-$80,000

$75,000 -30,000 -23,333 $21,667 7,583 $14,083 23,333 $37,417

$75,000 -30,000 -23,333 $21,667 7,583 $14,083 23,333 $37,417

-$80,000

$37,417

$37,417

HARD

t=3 $75,000 -30,000 -23,333 $21,667 7,583 $14,083 23,333 $37,417 10,000 5,000 1,750 $50,667

79.

(13-5) Sensitivity analysis

C I K

Answer: e

HARD

Base Case Calculations Investment cost Cars washed Price per car Variable cost/unit

WACC: 10% 2,800 $25.00 $5.375

Sales revenues − Fixed op. cost (excl. deprec.) $10,000 − Variable op costs $5.375 − Depreciation Rate = 33.333% Operating income (EBIT) − Taxes Rate = 35% EBIT(1 – T) + Depreciation Project CFs Base-Case NPV $30,068

t=0 -$60,000

-$60,000

t=1

t=2

t=3

2,800 $25.00 $5.375

2,800 $25.00 $5.375

2,800 $25.00 $5.375

$70,000 10,000 15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

$70,000 10,000 15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

$70,000 10,000 15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

Bad Case Calculations Investment cost Cars washed Price per car Variable cost/unit

t=0 -$60,000 Declines by: 40%

Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes EBIT(1 – T) + Depreciation Project CFs Bad-Case NPV Change in NPV

-$5,462 -$35,530

-$60,000

t=1

t=2

t=3

1,680 $25 $5.375

1,680 $25 $5.375

1,680 $25 $5.375

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

80.

(13A) NPV and depreciation

C I

81.

(13A) Depreciation cash flows

C I

Answer: a

EASY/MEDIUM

Answer: c

MEDIUM