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Exam 12: Cash Flow Estimation and Risk Analysis

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Question 41

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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

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Question 42

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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.

F) C) and D)
G) A) and B)

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Question 43

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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.

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: $\begin{array}{lll}&\text { Project } \mathrm{X}&\text { Project } \mathrm{Y}\\\text { Expected NPV } & \$ 350,000 & \$ 350,000 \\\text { Standard deviation (oNPV) } & \$ 100,000 & \$ 150,000 \\\text { Project beta (vs. market) } & 1.4 & 0.8\\\text { Correlation of the project cash flows }&\text { Cash flows are not correlated }&\text { Cash flows are highly correl ated }\\\text { with cash flows from currently }&\text { with the cash flows from }&\text { with the cash flows from }\\\text { existing projects. }&\text { existing projects. }&\text { existing projects. }\\\end{array}$ ? Which of the following statements is CORRECT?

Wilson Co.is considering two mutually exclusive projects.Both require an initial investment of $9,100 at t = 0.Project X has an expected life of 2 years with after-tax cash inflows of $5,500 and $8,200 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 $4,800 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? Do not round intermediate calculations.

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?

The relative risk of a proposed project is best accounted for by which of the following procedures?

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?

Which of the following rules is CORRECT for capital budgeting analysis?

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? $\begin{array} { l r } \text { Equipment cost (depreciable basis) } & \$ 48,000 \\\text { Sales revenues, each year } & \$ 60,000 \\\text { Operating costs (excl. depr.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$ ?

Which of the following statements is CORRECT?

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? Do not round the intermediate calculations and round the final answer to the nearest whole number. $\begin{array} { l r } \text { Sales revenues } & \$ 13,100 \\\text { Depreciation } & \$ 4,000 \\\text { Other operating costs } & \$ 6,000 \\\text { Tax rate } & 35.0 \%\end{array}$ ?

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 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.

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.

Which of the following statements is CORRECT?

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? Do not round the intermediate calculations and round the final answer to the nearest whole number. $\begin{array} { l r } \text { WACC } & 10.0 \% \\\text { Net investment in fixed assets (depreciable basis) } & \$ 70,000 \\\text { Required net operating working capital } & \$ 10,000 \\\text { Straight-line depreciation rate } & 33.333 \% \\\text { Annual sales revenues } & \$ 70,000 \\\text { Annual operating costs (excl. depreciation) } & \$ 30,000 \\\text { Expected pre-tax salvage value } & \$ 5,000 \\\text { Tax rate } & 35.0 \%\end{array}$ ?

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 $2,500.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? $\begin{array} { c c } \text { Year } & \text { Depreciation Rate } \\\hline 1 & 0.20 \\2 & 0.32 \\3 & 0.19 \\4 & 0.12 \\5 & 0.11 \\6 & 0.06\end{array}$ ?

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?

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? $\begin{array} { l r } \text { Equipment cost (depreciable basis) } & \$ 70,000 \\\text { Sales revenues, each year } & \$ 34,000 \\\text { Operating costs (excl. depr.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$ ?