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Exam 13: Capital Budgeting-Estimating Cash Flows and Analyzing Risk

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Question 41

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Spot-Free 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 new 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 decline? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) $\begin{array}{lr}\text { Project cost of capital (r) } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 60,000 \\\text { Number of cars washed } & 2,800 \\\text { Average price per car } & \$ 25.00 \\\text { Fixed op. cost (excl. deprec.) } & \$ 10,000 \\\text { Variable op. cost/unit (i.e., VC per car washed) } & \$ 5.375 \\\text { Annual depreciation } & \$ 20,000 \\\text { Tax rate } & 35.0 \%\end{array}$

A) $28,939
B) $30,462
C) $32,066
D) $33,753
E) $35,530

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

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Question 42

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Which of the following factors should be included in the cash flows used to estimate a project's NPV?

A) interest on funds borrowed to help finance the project.
B) the end-of-project recovery of any working capital required to operate the project.
C) cannibalization effects, but only if those effects increase the project's projected cash flows.
D) expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
E) all costs associated with the project that have been incurred prior to the time the analysis is being conducted.

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

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Question 43

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Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

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.

Any cash flows that can be classified as incremental to a particular project-i.e., results directly from the decision to undertake the projectσshould be reflected in the capital budgeting analysis.

Sheridan Films 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, some new 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? $\begin{array}{lr}\text { Project cost of capital ( } r \text { ) } & 10.0 \% \\\text { Net investment in fixed assets (depreciable basis) } & \$ 70,000 \\\text { Required new working capital } & \$ 10,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 30,000 \\\text { Expected pretax salvage value } & \$ 5,000 \\\text { Tax rate } & 350 \%\end{array}$

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.

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.

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.

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.

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.

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.

Which of the following statements is CORRECT?

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.

Tallant 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: $\begin{array}{lrr}& \text { Project X }& \text { Project Y } \\\text { Expected NPV } & \$ 500,000 & \$ 500,000 \\\text { Standard deviation (oNPV) } & \$ 200,000 & \$ 250,000 \\\text { Project beta (vs. market) }& 1.4 & 0.8\end{array}$ Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.σσWhich of the following statements is CORRECT?

While developing a new product line, Cook 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. Cook owns the building free and clearσthere is no mortgage on it. Which of the following statements is CORRECT?

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.