Q&A Hero

Q: Proceeds from the issuance of new debt and principal payments upon maturity of debt used to finance a project should be included in the calculation of the project's after-tax cash flows.

Q: Terminal cash flows are always positive because they result from the shutting down of a project with the sale of any assets with remaining value.

Q: Any increase in interest payments caused by a project should be counted in the incremental cash flows.

Q: Increases in working capital needs should be included as part of the initial outlay of a project, but decreases in working capital for a project should not be considered because they are not guaranteed.

Q: Increasing depreciation expense results in a decrease of the incremental after-tax free cash flow.

Q: Cash flows associated with a project's termination generally include the salvage value of the project net of any taxes associated with the sale.

Q: If the increase in net working capital is recovered entirely at the end of the project, then it may be ignored.

Q: The initial outlay includes the immediate cash outflow necessary to purchase the asset and put it in operating order.

Q: A weakness in the capital budgeting process is the funds for an investment proposal obtained by issuing bonds, and the respective interest payments, are not considered in the capital budgeting process.

Q: The initial outlay of a project may be reduced by the after-tax salvage value of replaced equipment.

Q: One example of a terminal cash flow is the recapture of the net working capital associated with the project.

Q: If an old asset is sold for its depreciated, or book, value, then no taxes result and there is no tax effect from the sale.

Q: If an old asset is sold for less than its book value, the resulting loss will save the company taxes, hence lowering the cost of the project.

Q: In general, a project's free cash flows will fall in one of the following three categories: initial outlay, differential cash flows over the project's life, and the terminal cash flow.

Q: What is an incremental cash flow? What is a sunk cost? Why must you account for opportunity costs?

Q: As part of its expansion project, A.J. Industries Equipment Division has expanded its office space by 200 square feet. The company's administrative overhead is allocated based on the square footage of each business segment. Although the total administrative overhead for the company will remain the same, the Equipment Division will be charged more for administrative overhead. For the Equipment Division expansion project, the administrative overhead is an example of a(n) A) incremental cash flow. B) sunk cost. C) opportunity cost. D) incremental opportunity cash flow.

Q: A company is expanding and has already signed a lease on new office space that costs $10,000 per month. The company also needs a new information system and hired a consultant to recommend new software. The consultant was paid $5,000 for her recommendation. Now the company is trying to make a choice between three competing software products. In the capital budgeting decision to purchase new software, the monthly rent for the office space is ________ and the consultant's fee is ________. A) a sunk cost; a sunk cost B) an opportunity cost; a sunk cost C) incremental cash outflow; an opportunity cost D) a sunk cost; a part of the initial outlay

Q: Which of the following expenses associated with a project should NOT be included in a capital budgeting analysis? A) additional allocated fixed overhead from corporate headquarters B) additional maintenance expenses associated with new equipment C) reengineering of a production line associated with a new project D) training sales staff on a new product

Q: It is important to consider a new project's affect on the cash flows of existing projects because of A) cannibalism. B) synergy. C) sunk costs. D) A and B above.

Q: Which of the following should be included in an analysis of a new project's cash flows? A) any sales from existing products that would be lost if customers were expected to purchase a new product instead B) all financing costs C) all sunk costs D) no opportunity costs

Q: Incremental cash flows refer to A) the difference between after-tax cash flows and before-tax accounting profits. B) the new cash flows that will be generated if a project is undertaken. C) the cash flows of a project, minus financing costs. D) the cash flows that are foregone if a firm does not undertake a project.

Q: Butler Automotive developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Butler expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of an increase in net working capital requirements from the new diagnostic testing procedure is the A) increase in inventory levels of oil and brake parts of $5,000. B) increase in revenue of $10,000 per month for the diagnostic testing. C) increase in revenues from oil changes and brake jobs of $4,000 per month. D) increase in all activities totaling $19,000 per month.

Q: Butler Automotive developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Butler expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of a synergistic effect from the new diagnostic testing procedure is the A) increase in inventory levels of oil and brake parts. B) increase in revenue of $10,000 per month for the diagnostic testing. C) increase in revenues from oil changes and brake jobs of $4,000 per month. D) increase in all activities totaling $19,000 per month.

Q: A local restaurant owner is considering expanding into another rural area. The expansion project will be financed through a line of credit with City Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy an existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include A) $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent. B) $500 administrative costs, $2,500 per month rent. C) $1,000 per month interest payments, $2,500 per month rent. D) $2,500 per month rent.

Q: AFB Systems is considering a new marketing campaign that will require the addition of a new computer programmer and new software. The programmer will occupy an office in AFB's current building and will be paid $8,000 per month. The software license costs $1,000 per month. The rent for the building is $4,000 per month. AFB's computer system is always on, so running the new software will not change the current monthly electric bill of $900. The incremental expenses for the new marketing campaign are A) $13,900 per month. B) $9,000 per month. C) $13,000 per month. D) $8,000 per month.

Q: Redrock Inc. is a household products firm that is considering developing a new detergent. In evaluating whether to go ahead with the new detergent project, which of the following statements is MOST correct? A) The company will produce the detergent in a building that they already own. The cost of the building is therefore zero and should be excluded from the analysis. B) The company will need to use some equipment that it could have leased to another company. This equipment lease could have generated $200,000 per year in after-tax income. The $200,000 should be excluded because the equipment can no longer be leased. C) The company will need to hire 10 new workers whose salaries and benefits will total $400,000 per year. Labor costs are not part of capital budgeting and should be excluded. D) The company will produce the detergent in a building that it renovated 2 years ago for $300,000. The $300,000 should be excluded from the analysis.

Q: Solar Confectionary develops a new candy bar and plans to sell each bar for $1. Solar predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold, and includes $1 million of incremental revenues in its capital budgeting analysis. A senior executive in the company believes that 1 million candy bars will be sold, but lowers the estimate of incremental revenue to $700,000. What would explain this change? A) cannibalization of 300,000 of Solar Confectionary's other candy bars B) excessive marketing costs to sell the 1 million candy bars C) a lower discount rate D) a higher selling price for the new candy bars

Q: Sunk costs are A) recoverable. B) incremental. C) not relevant in capital budgeting. D) not deductible for tax purposes.

Q: Tillamook Farms invests in a new kind of frozen dessert called polar cream that becomes very popular. So many new customers come to the store that the sales of existing ice cream products are increased. The extra sales revenue A) should not be counted as incremental revenue for the polar cream project because the sales come from existing products. B) are synergistic effects that should be counted as incremental revenues for the polar cream project. C) are cannibalized sales that should be excluded from the analysis. D) should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring expense.

Q: The calculation of incremental free cash flows over a project's life should include A) labor and material saving. B) additional revenue. C) interest to bondholders. D) A and B.

Q: An opportunity cost is a relevant incremental cost for capital budgeting decisions.

Q: TRL, Inc. has spent $2,000,000 in nonrefundable engineering fees in contemplation of building a convention center and the additional costs to complete the project are $18,000,000. The present value of all benefits the center will produce in its lifetime are $19,000,000, so TRL should not build the convention center.

Q: For companies in competitive markets, the evolution and introduction of new products may serve more to preserve market share than to expand it.

Q: If a project uses an asset the corporation already owns, the cost of that asset for capital budgeting purposes is zero to reflect the advantage the project has over projects that require the purchase of new assets.

Q: As a rule, any cash flows that are not affected by the accept/reject criterion should not be included in capital-budgeting analysis.

Q: Adding gourmet coffee stations to my convenience store is expected to increase sales of my breakfast sandwiches; however, the sales of breakfast sandwiches should not be included in the evaluation of the gourmet coffee project because only relevant, incremental cash flows should be considered.

Q: Hershey's expects to sell $2 million of its new candy bar, although $200,000 of this amount would have been spent on its existing candy bar. The $2 million is the appropriate cash inflow for the new candy bar project, while the $200,000 will be counted against the return on the old candy bar.

Q: Accounting profits, adjusted for taxes and differences in accounting methods, provide the best measure of relevant cash flows for capital budgeting purposes.

Q: Toyota's capital budgeting analysis for the Prius, a gas-electric hybrid, was faulty because the car line has not made a profit to date.

Q: Synergistic benefits from an investment project include cannibalism.

Q: The initial outlay for a new project is an example of an opportunity cost.

Q: In measuring cash flows, we are interested only in the incremental or incremental after-tax cash flows that are attributed to the investment proposal being evaluated.

Q: To be included in a capital budgeting analysis, all incremental free cash flows must be expensed on the company's books, otherwise generally accepted accounting principles will be violated.

Q: Interest payments on a loan obtained specifically to fund a new project should be considered an incremental cash flow for the new project when determining the accept/reject decision.

Q: Overhead costs are sometimes incremental cash flows and other times are considered sunk costs.

Q: Sunk costs are cash outflows that will occur regardless of the current accept/reject decision, and therefore should be excluded from the analysis.

Q: Additional investment in working capital, even if it may be recovered at the end of a project, must be included in capital budgeting analysis because of the time value of money.

Q: A grocery store decides to offer beer for sale and this decision results in more potato chip sales. This is an example of a synergistic effect.

Q: The guiding rule in deciding if a free cash flow is incremental is to look at the company with, versus without, the new project.

Q: Capital budgeting decisions are based on free cash flow because free cash flow better reflects when money is received and available for reinvestment than account profits.

Q: Accounting profits are used to make capital budgeting decisions because generally accepted accounting principles ensure that profits are the best measure of a company's economic activity.

Q: What is the most commonly used method for incorporating risk into the capital-budgeting decision? How is this technique related to Principle 3: Risk Requires a Reward?

Q: John Q. Enterprises is considering two potential investments. The probability distributions of annual end-of-year cash flows for the respective projects are:Project AProject BProbabilityOutcomeProbabilityOutcome0.25$10,0000.25$12,0000.50$15,0000.50$15,0000.25$20,0000.25$18,000Both projects will require an initial outlay of $45,000 and will have an estimated life of 6 years. Project A is considered a riskier investment and will have to have a risk-adjusted required rate of return of 15%, while Project B's risk-adjusted required rate of return is 12%.a. Determine the expected value of each project's annual cash flow.b. Determine each project's risk-adjusted net present value.

Q: KLE Holdings is considering a capital budgeting project with a life of 7 years that requires an initial outlay of $277,400. The probability distribution for annual incremental cash flows is as follows:ProbabilityIncremental Free Cash Flow4%-$15,00016%18,00055%65,00025%99,000a. The risk-adjusted required rate of return for this project is 12%. Calculate the risk-adjusted net present value of the project and the project's IRR.b. Should the project be accepted?

Q: The financial manager selecting one of two projects of differing risk should A) select the project with the larger risk-adjusted net present value. B) choose the project with the least relative risk. C) choose the project with greater return even if that project has greater risk. D) choose the project with less risk even though that project has less return.

Q: Which of the following is NOT an acceptable method of measuring risk for capital budgeting purposes? A) modified internal rate of return B) sensitivity analysis C) using a risk-adjusted discount rate D) proxy, or pure play method for estimating a project's beta

Q: The simulation approach provides us with A) a single value for the risk-adjusted net present value. B) an approximation of the systematic risk level. C) a probability distribution of the project's net present value or internal rate of return. D) a graphic exposition of the year-by-year sequence of possible outcomes.

Q: What method is used for calculation of the accounting beta? A) simulation B) regression analysis C) sensitivity analysis D) both A and C

Q: Advantages of using simulation include A) adjustment for risk in the resulting distribution of net present values. B) a range of possible outcomes presented. C) is good only for single period investments since discounting is not possible. D) graphically displays all possible outcomes of the investment.

Q: Creighton Industries is considering the purchase of a new strapping machine, which will cost $150,000, plus an additional $10,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $45,000 per year and is expected to save $16,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $20,000. Creighton's income tax rate is 35%. Creighton uses a 12.5% discount rate for capital budgeting purposes. What is the machine's NPV? A) $29,888 B) $25,062 C) $22,153 D) $27,894

Q: One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project. This method is referred to as A) the accounting beta method. B) scenario analysis. C) the pure play method. D) sensitivity analysis.

Q: Humongous Corporation is a multidivisional conglomerate. The Food Division is undergoing a capital budgeting analysis and must estimate the division's beta. This division has a different level of systematic risk than is typical for Humongous Corporation as a whole. The most appropriate method for estimating this beta is A) the regression coefficient from a time series regression of Humongous Corporation stock returns on a market index. B) to multiply the company's beta by the ratio of the Food Division's total assets/Humongous Corporation total assets. C) the regression coefficient from a time series regression of Food Division's net income on the Humongous Corporation's return on assets. D) the regression coefficient from a time series regression of Food Division's return on assets on a market index.

Q: Which of the following is NOT an important consideration in measuring risk for a capital budgeting project for a well-diversified firm? A) systematic risk B) contribution to firm risk C) total project risk D) None of the aboveall may be important in measuring project risk.

Q: The pure play method A) calculates beta using only project returns. B) uses the beta of a firm that is similar to the project being analyzed to determine the required rate of return for the project. C) selects a firm similar to the project being analyzed and uses its returns as the market return in estimating a project beta. D) selects one of the firm's existing projects that is similar to the project being analyzed and uses that project's required rate of return.

Q: A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven, and another capital budgeting project involving research and development into synthetic food substitutes. Which of the following statements is MOST correct concerning the risk-adjusted discount rate(s) for the projects? A) The rate will likely be higher for the replacement project because the likelihood of success is higher. B) The rate will likely be higher for the research and development project because of the uncertainty involved with research and development projects. C) The rate should be the same for both projects because they are being considered by one company with the same common shareholders. D) The rate should be higher for the replacement project because the company is more certain of the returns from a project similar to their existing business.

Q: Which of the following statements about project standing alone risk is true? A) It ignores the fact that much of the risk of a project will be diversified away as the project is combined with the firm's other projects. B) It ignores the cash flows that are associated with a project that occur beyond the payback period. C) It takes into consideration the effects of diversification of the firm's shareholders. D) It provides the best measure of project risk for a large, widely-held company.

Q: Which of the following is the most relevant measure of risk for capital budgeting purposes? A) project standing alone risk B) contribution-to-firm risk C) symbiotic risk D) unsystematic risk

Q: If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk is relevant when evaluating project risk in capital budgeting? A) total project risk B) contribution-to-firm risk C) systematic risk D) capital rationing risk

Q: Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net worth. When considering capital budgeting projects for their boutiques, the appropriate measure of risk is A) project standing alone risk. B) systematic risk. C) contribution-to-firm risk. D) beta risk.

Q: A wildcat oil driller has enough capital to invest in only one project, that is, to drill one well in an East Texas oil field. A major oil company is drilling 100 wells in the same field. The probability of successfully striking oil is 10% for any well drilled in this field. Which of the following statements is MOST correct concerning the risk involved in these capital budgeting projects? A) The risk for the wildcat driller is the same as the risk for the major oil company since they are both drilling in the same oil field. B) The appropriate risk for the wildcat driller is systematic risk. C) The appropriate risk for the major oil company is contribution-to-firm risk, if all shareholders of the firm are well diversified. D) The best measure of risk for the wildcat oil driller is project standing alone risk.

Q: Using simulation provides the financial manager with a probability distribution of an investment's net present value or internal rate of return.

Q: Reducing the probability of bankruptcy is a benefit of diversification.

Q: A typical decision rule used in simulation is to accept the project if the probability is sufficiently high that the net present value is positive.

Q: Sensitivity analysis involves changing one variable at a time.

Q: A method for estimating a project's beta that attempts to identify publicly traded firms engage solely in the same business as the project is called the pure play method.

Q: The less-risky investment is always the more desirable choice.

Q: The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same firm when considering a new product line.

Q: Financial theory assumes that individuals are risk averse.

Q: If the cash flows of an accepted investment project are negatively correlated with the average cash flow of the firm's existing assets, then the company's total exposure to risk can decrease.

Q: The risk-adjusted discount rate method implicitly assumes that distant cash flows have the same risk as near cash flows.