Exam 12: Cash Flow and Risk

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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.

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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 straight-line 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.

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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.

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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.

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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.

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A) $1,345.50
B) $1,346.30
C) $1,361.52
D) $1,376.74
E) $1,411.15

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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.

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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.

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

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