Chapter 11: Cash Flow Estimation and Risk Analysis: Page 1

Chapter 11: Cash Flow Estimation and Risk Analysis
1. 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. Fals
e
ANSWER: False
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DIFFICULTY Difficulty: Easy
:
QUESTION T True / False
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LEARNING O FMTP.EHRH.20.11.01 - LO: 11-1
BJECTIVES:
NATIONAL S United States - BUSPROG: Reflective Thinking
TANDARDS:
STATE STAN United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting
DARDS: and cost of capital
United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements,
analysis, forecasting, and cash flows
LOCAL STAN United States - OH - Default City - TBA
DARDS:
TOPICS: Cash flow estimation
KEYWORDS: Bloom’s: Knowledge
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2. 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. Fals
e
ANSWER: True
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3. 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. Fals
e
ANSWER: False
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4. 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. Fals
e
ANSWER: False
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5. 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
b. Fals
e
ANSWER: True
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6. 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. Fals
e
ANSWER: False
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7. 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. Fals
e
ANSWER: True
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8. 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. Fals
e
ANSWER: False
POINTS: 1
DIFFICULTY: Difficulty: Easy
QUESTION TYPE: True / False
HAS VARIABLES: False
LEARNING OBJEC FMTP.EHRH.20.11.01 - LO: 11-1
TIVES:
NATIONAL STAND United States - BUSPROG: Reflective Thinking
ARDS:
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S: budgeting and cost of capital
LOCAL STANDARD United States - OH - Default City - TBA
S:
TOPICS: Externalities
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9. In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects
on the firm's long-run cash flows.
a. True
b. Fals
e
ANSWER: True
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10. 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. Fals
e
ANSWER: False
RATIONALE: 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 the possible effects of the
externality.
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11. 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.
a. True
b. Fals
e
ANSWER: False
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DIFFICULTY Difficulty: Moderate
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KEYWORDS: Bloom’s: Comprehension
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12. 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. Fals
e
ANSWER: True
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13. The two cardinal rules that financial analysts should follow to avoid capital budgeting 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.
a. True
b. Fals
e
ANSWER: False
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14. 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. Fals
e
ANSWER: True
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DIFFICULTY: Difficulty: Moderate
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TOPICS: Opportunity costs
15. 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. Fals
e
ANSWER: False
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TOPICS: Sunk costs
16. 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. Shipping and installation costs.
b. Cannibalization effects.
c. Opportunity costs.
d. Sunk costs that have been expensed for tax purposes.
e. Changes in net working capital.
ANSWER: d
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BJECTIVES:
NATIONAL S United States - BUSPROG: Analytic
TANDARDS:
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TOPICS: Cash flow issues
OTHER: TYPE: Multiple Choice: Conceptual
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17. Which of the following statements is CORRECT?

a. 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.
b 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.

c. Sunk costs were formerly hard to deal with but now that the NPV method is widely
used, it is possible to simply include sunk costs in the cash flows and then calculate the
PV of the project.
d 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.
e. A sunk cost is any cost that must be expended in order to complete a project and bring
it into operation.
ANSWER: b
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TOPICS: Sunk costs

a. Sunk costs must be considered if the IRR method is used but not if the firm relies on
the NPV method.
b 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.
c. 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.
d 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 be.
e. An example of a sunk cost is the cost associated with restoring the site of a strip mine
once the ore has been depleted.
ANSWER: c
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a. 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.
b 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.
c. Both the NPV and IRR methods deal correctly with externalities, even if the
externalities are not specifically identified. However, the payback method does not.
d Identifying an externality can never lead to an increase in the calculated NPV.
.
e. 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.
ANSWER: a
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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 customers. Thus, cannibalization is dealt with by society

through the antitrust laws.
b 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.
c. 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.
d 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.
e. 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.
ANSWER: d
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21. The CFO of Cicero Industries plans to calculate a new 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 flow), 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 investment in 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.
ANSWER: c
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22. 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.
ANSWER: b
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23. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
a. Previous expenditures associated with a market test to determine the feasibility of the
project, provided those costs have been expensed for tax purposes.
b The value of a building owned by the firm that will be used for this project.
.
c. A decline in the sales of an existing product, provided that decline is directly
attributable to this project.
d The salvage value of assets used for the project that will be recovered at the end of the
. project's life.
e. Changes in net working capital attributable to the project.
ANSWER: a
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24. 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 clear⎯there is no mortgage on it. Which of the following statements is CORRECT?
a. 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.
b 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.
c. 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.
d 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.
e. 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 for any new
project.
ANSWER: a
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25. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed
project?
a. 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.
b The company has spent and expensed $1 million on R&D associated with the new
. project.
c. The company spent and expensed $10 million on a marketing study before its current
analysis regarding whether to accept or reject the project.
d 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.
e. The new project is expected to reduce sales of one of the company's existing products
by 5%.
ANSWER: e
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26. Collins Inc. is investigating whether to develop 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 project will utilize some equipment the company currently owns but is not now
using. A used equipment dealer has offered to buy the equipment.
b The company has spent and expensed for tax purposes $3 million on research related
. to the new detergent. These funds cannot be recovered, but the research may benefit
other projects that might be proposed in the future.
c. The new product will cut into sales of some of the firm's other products.
d If the project is accepted, the company must invest $2 million in working capital.
. However, all of these funds will be recovered at the end of the project's life.
e. 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.
ANSWER: b
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27. Which of the following rules is CORRECT for capital budgeting analysis?

a. Only incremental cash flows, which are the cash flows that would result if a project is
accepted, are relevant when making accept/reject decisions.
b 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.
c. 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.
d 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.
e. The interest paid on funds borrowed to finance a project must be included in estimates
of the project's cash flows.
ANSWER: a
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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 a downward bias in the NPV.
b The existence of any type of "externality" will reduce the calculated NPV versus the
. NPV that would exist without the externality.
c. 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 after-tax proceeds that could be obtained should be charged as
a cost to the project under consideration.
d 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.
e. 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.
ANSWER: c
RATIONALE: Regarding e and a, note that since interest should not be considered, exclusion will
not lead to any type of bias, positive or negative.
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29. 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 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.
b A firm must obtain new equipment for the project, and $1 million is required for
. shipping and installing the new machinery.
c. A firm has spent $2 million on R&D 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.
d A firm can produce a new product, and the existence of that product will stimulate
. sales of some of the firm's other products.
e. 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.
ANSWER: c
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TOPICS: Incremental cash flows

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30. 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. Revenues from an existing product would be lost as a result of customers switching to
the new product.
b Shipping and installation costs associated with a machine that would be used to
. produce the new product.
c. 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.
d 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.
e. 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.
ANSWER: c
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a. 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.
b 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.
c. Both the NPV and IRR methods deal correctly with externalities, even if the
externalities are not specifically identified. However, the payback method does not.
d Identifying an externality can never lead to an increase in the calculated NPV.
.
e. 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.
ANSWER: a
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32. Changes in net 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. Fals
e
ANSWER: False
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TOPICS: Changes in NWC
33. 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. Fals
e
ANSWER: False
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TOPICS: Depreciation cash flows
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34. 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. Fals
e
ANSWER: True
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35. 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. Fals
e
ANSWER: False
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36. 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. Fals
e
ANSWER: True
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37. 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. Fals
e
ANSWER: True
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38. The change in net working capital associated with new projects is always positive, because new projects mean that
more working capital will be required. This situation is especially true for replacement projects.
a. True
b. Fals
e
ANSWER: False
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Net working capital
39. 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. Fals
e
ANSWER: False
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:

a. Under current laws and regulations, corporations must use straight-line depreciation
for all assets whose lives are 5 years or longer.
b Corporations must use the same depreciation method (e.g., straight line or accelerated)
. for stockholder reporting and tax purposes.
c. Since depreciation is not a cash expense, it has no effect on cash flows and thus no
effect on capital budgeting decisions.
d 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.
e. 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.
ANSWER: e
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Depreciation

b Corporations must use the same depreciation method for both stockholder reporting
. and tax purposes.
c. Using accelerated depreciation rather than straight line normally has the effect of
speeding up cash flows and thus increasing a project's forecasted NPV.
d Using accelerated depreciation rather than straight line normally has no effect on a
. project's total projected cash flows nor would it affect the timing of those cash flows or
the resulting NPV of the project.
e. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the
projected NPV from investing in the asset.
ANSWER: c
POINTS: 1
TIVES:
ARDS:
S:

b If firms use accelerated depreciation, they 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.

c. 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.
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
higher than they would be if straight-line depreciation were required for tax purposes.
e. 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.
ANSWER: d
POINTS: 1
TIVES:
ARDS:
S:
43. To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is
CORRECT?
a. Since depreciation is a non-cash expense, the firm does not need to deal with
depreciation when calculating the operating cash flows.
b 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.
c. Capital budgeting decisions should be based on before-tax cash flows.
d The cost of capital used to discount cash flows in a capital budgeting analysis should
. be calculated on a before-tax basis.
e. 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 cost of capital. If interest were deducted when estimating cash
flows, this would, in effect, "double count" it.
ANSWER: e
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: New project cash flows
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:

a. 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.
b It is unrealistic to believe that any increases in net working capital required at the start
. of an expansion project can be recovered at the project's completion. Working capital
like inventory is almost always used up in operations. Thus, cash flows associated with
working capital should be included only at the start of a project's life.
c. 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.
d Changes in net working capital refer to changes in current assets and current liabilities,
. not to changes in long-term assets and liabilities. Therefore, changes in net working
capital should not be considered in a capital budgeting analysis.
e. 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.
ANSWER: c
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: CFs and accounting measures
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
45. You have just landed an internship in the CFO's office of Hawkesworth Inc. Your first task is to estimate the Year 1
cash flow for a project with the following data. What is the Year 1 cash flow?
Sales revenues $13,000
Depreciation $4,000
Other operating costs $6,000
Tax rate 25.0%
a. $6,250
b. $6,406
c. $6,566
d. $6,731
e. $6,899
ANSWER: a
RATIONALE: Sales revenues $13,000
− Operating costs (excl. deprec.) 6,000
− Depreciation 4,000
Operating income (EBIT) $ 3,000
− Taxes Rate = 25% 750
After-tax EBIT $ 2,250
+ Depreciation 4,000
Cash flow, Year 1 $ 6,250
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Annual CF
KEYWORDS: Bloom’s: Application
OTHER: TYPE: Multiple Choice: Problem
NOTES: This question is not conceptually hard, but may require a significant amount of
arithmetic. The additional work will increase the length of time that students need
to find the correct answer.
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 7:54 PM
FIED:
46. In your first job with TBL Inc. your task is to consider a new project whose data are shown below. What is the
project's Year 1 cash flow?
Depreciation $8,000
Tax rate 25.0%
a. $9,115
b. $9,397
c. $9,688
d. $9,978
e. $10,277
ANSWER: c
RATIONALE: Sales revenues $22,250
Operating income (EBIT) $ 2,250
− Taxes Rate = 25% 563
After-tax EBIT $ 1,688
Cash flow, Year 1 $ 9,688
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Annual CF
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 7:56 PM
FIED:
47. Fitzgerald Computers 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) $65,000
Straight-line depreciation rate 33.333%
Sales revenues, each year $60,000
Operating costs (excl. deprec.) $25,000
Tax rate 25.0%
a. $29,351
b. $30,103
c. $30,875
d. $31,667
e. $32,458
ANSWER: d
RATIONALE: Equipment life, years 3
Equipment cost $65,000
Depreciation: Rate = 33.333% $21,667

− Basis × rate = depreciation 21,667
Operating income (EBIT) $13,333
− Taxes Rate = 25.0% 3,333
After-tax EBIT $10,000
Cash flow, Year 1 $31,667
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
STATE STAN United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
DARDS: United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting,
and cash flows
DARDS:
TOPICS: Annual CF
NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic. The
additional work will increase the length of time that students need to find the correct answer.
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 7:59 PM
FIED:
48. VR Corporation has the opportunity to invest in a new project, the details of which are shown below. What is the Year
1 cash flow for the project?
Depreciation $10,000
Interest expense $4,000
Tax rate 25.0%
a. $17,614
b. $18,541
c. $19,517
d. $20,544
e. $21,625
ANSWER: e
RATIONALE: This problem is a bit harder than some of the other 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.
− Taxes Rate = 25% 3,875
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS: United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis,
forecasting, and cash flows
DARDS:
TOPICS: Annual CF
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 8:01 PM
FIED:
49. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What is the
project's Year 1 cash flow?
Depreciation $8,000
Interest expense $8,000
Tax rate 25.0%
a. $28,619
b. $30,125
c. $31,631
d. $33,213
e. $34,873
ANSWER: b
RATIONALE: This problem is a bit harder than some of the other 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.
− Taxes Rate = 25% 7,375
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Annual CF
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 8:03 PM
FIED:
50. Your new employer, Freeman 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 33.33%, 44.45%,
14.81%, and 7.41% 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?
Tax rate 25.0%
a. $31,666
b. $31,849
c. $33,442
d. $35,114
e. $36,869
ANSWER: a
RATIONALE: Equipment cost $65,000
Depreciation rate 33.33%

− Taxes Rate = 25% 3,334
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Annual CF
MACRS
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 8:30 PM
FIED:
51. Whitestone Products 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 33.33%, 44.45%, 14.81%, and 7.41% 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?
Tax rate 25.0%
a. $13,016
b. $13,701
c. $14,422
d. $15,143
e. $15,900
ANSWER: c
RATIONALE: Equipment cost $70,000
Depreciation rate, Year 4 7.41%


− Taxes Rate = 25% 3,078
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Annual CF
MACRS
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 8:08 PM
FIED:
52. DeVault Services recently hired you as a consultant to help with its capital budgeting process. The company 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 new 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 cost of capital 10.0%
Net investment cost (depreciable basis) $65,000
Straight-line deprec. rate 33.3333%
Operating costs (excl. deprec.), each year $25,000
Tax rate 25.0%
a. $34,515

b. $36,331
c. $38,243
d. $40,256
e. $42,375
ANSWER: e
RATIONALE: RATIONALE WACC 10.0%
: Tax rate 25%
Depreciation rate 33.33%
Year 0 1 2 3
Investment cost −$65,000
Sales revenues $65,500 $65,500 $65,500
−Op.costs (excl. depr.) 25,000 25,000 25,000
−Depreciation
21,667 21,667 21,667
(33.333%)
Operating income
$18,833 $18,833 $18,833
(EBIT)
−Taxes (25%) 4,708 4,708 4,708
After-tax EBIT $14,125 $14,125 $14,125
+ Depreciation 21,667 21,667 21,667
Cash flow −$65,000 $35,792 $35,792 $35,792
NPV $42,375

POINTS: 1
:
YPE:
HAS VARIAB False
LES:
LEARNING FMTP.EHRH.20.11.02 - LO: 11-2
OBJECTIVES
:
TANDARDS:
DARDS: United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting,
and cash flows
DARDS:
TOPICS: Project NPV
NOTES: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional
work will increase the length of time that students need to find the correct answer.
DATE CREA 8/9/2018 11:04 AM
TED:
DATE MODI 1/27/2019 8:13 PM
FIED:
53. Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an
end. 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 25%. 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. $5,611
b. $5,906
c. $6,202
d. $6,512
e. $6,837
ANSWER: b
RATIONALE: % depreciated on equip. 75%
Tax rate 25%

Equipment cost $22,500
− Accumulated deprec. 16,875
Current book value of equipment $ 5,625
Market value of equipment 6,000
Gain (or loss): Market value − Book
$ 375
value
Taxes paid on gain (−) or credited
−94
(+) on loss
AT salvage value = market value +/
$ 5,906
− taxes
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Salvage value
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 1/27/2019 8:19 PM
FIED:
54. McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation.
The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to
operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 25%, what will the after-tax
salvage value be when the machine is sold at the end of Year 4?
Year Depreciation Rate
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
a. $9,367
b. $9,860
c. $10,379
d. $10,925
e. $11,500
ANSWE e
R:
RATIO Yea
NALE: Deprec. Annual r-
end
Boo
Y
Basi k
ea Rate Deprec.
s Val
r
ue
$50, $40,
1 0.20 $10,000
000 000
50,0 24,0
2 0.32 16,000
00 00
50,0 14,5
3 0.19 9,500
00 00
50,0 8,50
4 0.12 6,000
00 0
50,0 3,00
5 0.11 5,500
00 0
50,0
6 0.06 3,000 0
00
1.00 $50,000
Gross sales proceeds (Market value) $12,500
Book value, end of Year 4 8,500
Profit $ 4,000
Tax on profit Rate = 25% 1,000
AT salvage value = market value +/− taxes $11,500
POINT 1
S:
DIFFIC Difficulty: Moderate
ULTY:
QUEST Multiple Choice
ION TY
PE:
HAS V False
ARIAB
LES:
LEARN FMTP.EHRH.20.11.02 - LO: 11-2
ING O
BJECTI
VES:
NATIO United States - BUSPROG: Analytic
NAL ST
ANDAR
DS:
STATE United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
STAND
ARDS:
LOCAL United States - OH - Default City - TBA
STAND
ARDS:
TOPIC Salvage value
S:
KEYW Bloom’s: Analysis
ORDS:
OTHER TYPE: Multiple Choice: Problem
:
NOTES This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work
: will increase the length of time that students need to find the correct answer.
DATE 8/9/2018 11:04 AM
CREAT
ED:
DATE 1/27/2019 8:21 PM
MODIF
IED:
55. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below. The
equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage
value, and no new 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 Weston's 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.)
Cost of capital 10.0%
Pre-tax cash flow reduction for other products (cannibalization) $5,000
Investment cost (depreciable basis) $80,000
Sales revenues, each year for 3 years $67,500
Annual operating costs (excl. deprec.) $25,000
Tax rate 25.0%
a. $6,196
b. $6,522
c. $6,848
d. $7,190
e. $7,550
ANS b
WE
R:
RAT t=0 t=1 t=2 t=3
ION Investment (Basis) WACC = 10% −$80,000
ALE Sales revenues $67,500 $67,500 $67,500
: − Cannibalization cost 5,000 5,000 5,000
− Operating costs (excl. deprec.) 25,000 25,000 25,000
− Basis × rate = deprec. Rate = 33.33% 26,667 26,667 26,667
Operating income (EBIT) $10,833 $10,833 $10,833
− Taxes Rate = 25% 2,708 2,708 2,708
After-tax EBIT $8,125 $8,125 $8,125
+ Depreciation 26,667 26,667 26,667
Cash flow −$80,000 $34,792 $34,792 $34,792
NPV $6,522
POI 1
NTS
:
DIF Difficulty: Challenging
FIC
ULT
Y:
QU Multiple Choice
EST
ION
TYP
E:
HAS False
VAR
IAB
LES
:
LEA FMTP.EHRH.20.11.02 - LO: 11-2
RNI
NG
OBJ

ECT
IVE
S:
NAT United States - BUSPROG: Analytic
ION
AL
STA
ND
AR
DS:
STA United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
TE United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash
STA flows
ND
AR
DS:
LO United States - OH - Default City - TBA
CAL
STA
ND
AR
DS:
TO Project NPV
PIC
S:
KEY Bloom’s: Analysis
WO
RDS
:
OT TYPE: Multiple Choice: Problem
HE
R:
DA 8/9/2018 11:04 AM
TE
CR
EAT
ED:

DA 1/27/2019 8:25 PM
TE
MO
DIF
IED
:
56. Century Roofing is thinking of opening a new warehouse, 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 warehouse. 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 new 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.)
Project cost of capital (r) 10.0%

Opportunity cost $100,000
Net equipment cost (depreciable basis) $65,000
Straight-line deprec. rate for equipment 33.333%
Tax rate 25%
a. $26,796
b. $28,207
c. $29,691
d. $31,254
e. $32,817
ANSW d
ER:
RATI t=0 t=1 t=2 t=3
ONAL Investment WACC = 10% −$ 65,000
E: Opportunity cost −100,000
Revenues $123,000 $123,000 $123,000
− Basis × rate = deprec. Rate = 33.33% 21,667 21,667 21,667
Operating income (EBIT) $ 76,333 $ 76,333 $ 76,333
− Taxes Rate = 25% 19,083 19,083 19,083
After-tax EBIT $57,250 $57,250 $57,250
+ Depreciation 21,667 21,667 21,667
Cash flow −$165,000 $ 78,917 $ 78,917 $ 78,917
NPV $31,254
POIN 1
TS:
DIFFI Difficulty: Moderate
CULT
Y:
QUES Multiple Choice
TION
TYPE:

HAS False
VARI
ABLE
S:
LEAR FMTP.EHRH.20.11.02 - LO: 11-2
NING
OBJE
CTIV
ES:
NATI United States - BUSPROG: Analytic
ONAL
STAN
DARD
S:
STAT United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
E STA United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash
NDAR flows
DS:
LOCA United States - OH - Default City - TBA
L STA
NDAR
DS:
TOPI Project NPV
CS:
ORDS
:
OTHE TYPE: Multiple Choice: Problem
R:
DATE 8/9/2018 11:04 AM
CREA
TED:
DATE 1/27/2019 8:28 PM
MODI
FIED:

57. Garden-Grow Products 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 some
additional 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 are constant in Years 1 to 3.)
Net investment in fixed assets (basis) $75,000
Required new working capital $15,000
Tax rate 25.0%
a. $30,069
b. $31,573
c. $33,152
d. $34,809
e. $36,550
ANS a
WER
:
ONA Investment in fixed assets WACC = 10% −$75,000
LE: Investment in net working capital −$15,000
Sales revenues $75,000 $75,000 $75,000
Depreciation Rate = 33.333% 25,000 25,000 25,000
− Taxes Rate = 25% 6,250 6,250 6,250
After-tax EBIT $18,750 $18,750 $18,750
+ Depreciation 25,000 25,000 25,000
Cash flow from operations −$90,000 $43,750 $43,750 $43,750
Recovery of working capital 15,000
Total cash flows −$90,000 $43,750 $43,750 $58,750
NPV $30,069
POI 1
NTS:

FIC
ULT
Y:
QUE Multiple Choice
STIO
N TY
PE:
HAS False
VARI
ABL
ES:
LEA FMTP.EHRH.20.11.02 - LO: 11-2
RNI
NG
OBJ
ECTI
VES:

ONA
L ST
AND
ARD
S:
TE S United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash
TAN flows
DAR
DS:
LOC United States - OH - Default City - TBA
AL S
TAN
DAR
DS:
TOP Project NPV
ICS:
WOR
DS:

OTH TYPE: Multiple Choice: Problem
ER:
DAT 8/9/2018 11:04 AM
E C
REA
TED
:
DAT 1/27/2019 8:35 PM
E M
ODI
FIE
D:
58. 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?
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Expected pretax salvage value $5,000
Tax rate 25.0%
a. $25,964
b. $27,330
c. $28,768
d. $30,207
e. $31,717
ANS c
WER
:
ONA Investment in fixed assets WACC = 10% −$70,000
LE: Investment in net working capital −10,000
Sales revenues $75,000 $75,000 $75,000
Depreciation Rate = 33.333% 23,333 23,333 23,333
− Taxes Rate = 25% 5,417 5,417 5,417
After-tax EBIT $16,250 $16,250 $16,250
+ Depreciation 23,333 23,333 23,333
Cash flow from operations −$80,000 $39,583 $39,583 $39,583
Recovery of working capital 10,000
Salvage value, pre-tax 5,000
− Tax on salvage value Rate = 25% 1,250
Total cash flows −$80,000 $39,583 $39,583 $53,333
NPV $28,768
POI 1
NTS:

FIC
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QUE Multiple Choice
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HAS False
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LEA FMTP.EHRH.20.11.02 - LO: 11-2
RNI
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ONA
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TAN flows
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ICS:
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59. Shultz Business Systems 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. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm
projects. What is the project's expected NPV?
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. deprec. (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation rate per year 5.00%
Tax rate 25.0%
a. $27,625
b. $29,079
c. $30,610
d. $32,140
e. $33,747
ANSW c
ER:
RATIO Base Case Calculations
NALE: t=0 t=1 t=2 t=3
Investment cost WACC = 10% −$200,000
Inflation 5.0% 5.0% 5.0%
Price per unit $25.00 $26.25 $27.56
VC per unit $20.20 $21.21 $22.27
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000 $1,312,500 $1,378,125
− Fixed op. cost (excl. deprec.) 150,000 150,000 150,000
− Variable op costs 1,010,000 1,060,500 1,113,525
− Depreciation Rate = 33.333% 66,667 66,667 66,667
− Taxes Rate = 25% 5,833 8,833 11,983
After-tax EBIT $ 17,500 $ 26,500 $ 35,950
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 84,167 $ 93,167 $ 102,617
NPV $30,610
POINT 1
S:
DIFFI Difficulty: Challenging
CULT
Y:
QUES Multiple Choice
TION
TYPE:
HAS V False
ARIAB
LES:
NING
OBJE
CTIVE
S:
NATIO United States - BUSPROG: Analytic
NAL S
TAND
ARDS:

STATE United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
STAN United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash
DARD flows
S:
LOCA United States - OH - Default City - TBA
L STA
NDAR
DS:
TOPIC NPV including inflation
S:
ORDS:

OTHE TYPE: Multiple Choice: Problem
R:
DATE 8/9/2018 11:04 AM
CREA
TED:
DATE 1/27/2019 8:44 PM
MODI
FIED:
60. Sylvester Media 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. This is just one of many projects for the firm, so any losses 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 adjustment is required. What is the difference in the
expected NPV if the inflation adjustment is made vs. if it is not made?
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. deprec. (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation 4.00%
Tax rate 25.0%
a. $15,330
b. $16,136
c. $16,986
d. $17,835
e. $18,727
ANS c
WER:

RATI NPV with no adjustment
ONA t=0 t=1 t=2 t=3
LE: Investment cost WACC=10% −$200,000
Inflation (set to 0%) 0.0% 0.0% 0.0%
Price per unit $25.00 $25.00 $25.00
VC per unit $20.20 $20.20 $20.20
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000 $1,250,000 $1,250,000
− Variable op costs per unit = $20.20 1,010,000 1,010,000 1,010,000
− Taxes Rate = 25% 5,833 5,833 5,833
After-tax EBIT $ 17,500 $ 17,500 $ 17,500
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 84,167 $ 84,167 $ 84,167
NPV w/o infl. adjustment $9,310
NPV with adjustment
t=0 t=1 t=2 t=3
Investment cost WACC=10% −$200,000
Inflation 4.0% 4.0% 4.0%
Price per unit $25.00 $26.00 $27.04
VC per unit $20.20 $21.01 $21.85
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000 $1,300,000 $1,352,000
− Variable op costs per unit = $20.20 1,010,000 1,050,400 1,092,416
− Taxes Rate = 25% 5,833 8,233 10,729
After-tax EBIT $ 17,500 $ 24,700 $32,188
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 84,167 $91,367 $ 98,855
NPV w/infl. adjustment $26,296
Increase w/infl. adjustment $16,986
POIN 1
TS:
DIFF Difficulty: Challenging
ICUL
TY:
QUE Multiple Choice
STIO
N TY
PE:
HAS False
VARI
ABLE
S:
NING
OBJE
CTIV
ES:
ONA
L ST
AND
ARDS
:
STAT United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital
E ST United States - AK - Tier 2: Financial statements, an - Tier 2: Financial statements, analysis, forecasting, and cash
AND flows
ARDS
:
AL S
TAN
DAR
DS:
TOPI NPV including inflation
CS:
WOR
DS:
ER:
DATE 8/9/2018 11:04 AM
CREA
TED:
DATE 1/27/2019 8:50 PM
MOD
IFIE
D:
61. 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
b. Fals
e
ANSWER: True
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Risk-adjusted discount rate
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
62. Which of the following procedures best accounts for the relative risk of a proposed project?
a. Adjusting the discount rate downward if the project is judged to have above-average
risk.
b. Reducing the NPV by 10% for risky projects.
c. Picking a risk factor equal to the average discount rate.
d. Ignoring risk because project risk cannot be measured accurately.
e. Adjusting the discount rate upward if the project is judged to have above-average risk.
ANSWER: e
POINTS: 1
TIVES:
ARDS:

S:
TOPICS: Risk adjustment
63. Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital of 8% for
below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the
following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing
projects?
a. Project B, which has below-average risk and an IRR = 8.5%.
b. Project C, which has above-average risk and an IRR = 11%.
c. Without information about the projects' NPVs we cannot determine which project(s)
should be accepted.
d. All of these projects should be accepted.
e. Project A, which has average risk and an IRR = 9%.
ANSWER: a
POINTS: 1
TIVES:
ARDS:
S:
64. 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:
Project X Project Y
Expected NPV $500,000 $500,000
Standard deviation (σNPV) $200,000 $250,000
Project beta (vs. market) 1.4 0.8

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.
Which of the following statements is CORRECT?

a. Project X has more corporate (or within-firm) risk than Project
Y.
b. Project X has more market risk than Project Y.
c. Project X has the same level of corporate risk as Project Y.
d. Project X has less market risk than Project Y.
e. Project X has more stand-alone risk than Project Y.
ANSWER: b
RATIONALE: Statement b 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 a 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 b
is true.
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Risk analysis
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
65. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are
positively correlated with the overall economy. The company estimates that the 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 would increase the firm's corporate risk.
b. The proposed new project would increase the firm's market risk.
c. The proposed new project would not affect the firm's risk at all.
d. The proposed new project would have less stand-alone risk than the firm's typical
project.
e. The proposed new project would have more stand-alone risk than the firm's typical
project.
ANSWER: e
RATIONALE: Statement e 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.
POINTS: 1
:
YPE:
HAS VARIAB False
LES:
BJECTIVES:
TANDARDS:
DARDS:
TOPICS: Risk analysis
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:
66. 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 NPV of the project to reflect its greater risk.
b. Reject the project, since its acceptance would increase the firm's risk.
c. Ignore the risk differential if the project would amount to only a small fraction of the
firm's total assets.
d. Increase the cost of capital used to evaluate the project to reflect its higher-than-
average risk.
e. Increase the estimated IRR of the project to reflect its greater risk.
ANSWER: d
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Project's effect on firm risk
67. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%,
which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie evaluates low-risk
projects with a risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%.
The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.
ANSWER: c
RATIONALE: Statement b is true; the others are false. The following table shows the required
return for each project on the basis of its risk level.
Expected Req'd Return
Project Risk Return for This Risk Decision
A High 15% 12% Accept
B Average 12% 10% Accept
C High 11% 12% Reject
D Low 9% 8% Accept
E Low 6% 8% Reject
POINTS: 1
QUESTION TYP Multiple Choice
E:
HAS VARIABLE False
S:
LEARNING OBJ FMTP.EHRH.20.11.03 - LO: 11-3
ECTIVES:
NATIONAL STA United States - BUSPROG: Analytic
NDARDS:
STATE STANDA United States - AK - DISC: Capital budgeting and cost - DISC: Capital
RDS: budgeting and cost of capital
LOCAL STAND United States - OH - Default City - TBA
ARDS:
DATE CREATE 8/9/2018 11:04 AM
D:
DATE MODIFI 8/9/2018 11:04 AM
ED:
68. Because of differences in the expected returns on different investments, the standard deviation is not always an
adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows
investors to make better comparisons of investments' stand-alone risk.
a. True
b. Fals
e
ANSWER: True
POINTS: 1
LEARNING OBJECTIVES: FMTP.EHRH.20.11.03 - LO: 11-3
NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking
STATE STANDARDS: United States - AK - DISC: Risk and return
LOCAL STANDARDS: United States - OH - Default City - TBA
TOPICS: Coefficient of variation
69. 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. Fals
e
ANSWER: True
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Sensitivity analysis
70. 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.)
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost (excl. deprec.) $10,000
Variable op. cost/unit (i.e., VC per car washed) $5.375
Annual depreciation $20,000
Tax rate 25.0%
a. $33,391
b. $35,149
c. $36,999
d. $38,946
e. $40,996
ANS e
WER
:
RATI Base Case Calculations
ONA t=0 t=1 t=2 t=3
LE: Investment cost WACC: 10% −$60,000
Cars washed 2,800 2,800 2,800 2,800
Price per car $25.00 $25.00 $25.00 $25.00
Variable cost/unit $5.375 $5.375 $5.375 $5.375

Sales revenues $70,000 $70,000 $70,000
− Fixed op. cost (excl. deprec.) $10,000 10,000 10,000 10,000
− Variable op costs $5.375 15,050 15,050 15,050
− Taxes Rate = 25% 6,238 6,238 6,238
After-tax EBIT $18,713 $18,713 $18,713
+ Depreciation 20,000 20,000 20,000
Cash flow −$60,000 $38,713 $38,713 $38,713
Base-Case NPV $36,272
Bad Case Calculations
t=0 t=1 t=2 t=3
Investment cost −$60,000
Cars washed Declines by: 40% 1,680 1,680 1,680
Price per car $25.00 $25.00 $25.00
Variable cost/unit $5.375 $5.375 $5.375

Sales revenues $42,000 $42,000 $42,000
− Variable op costs 9,030 9,030 9,030
− Depreciation 20,000 20,000 20,000
− Taxes 743 1,040 1,040
After-tax EBIT $2,228 $1,931 $1,931
+ Depreciation 20,000 20,000 20,000
Cash flow −$60,000 $22,228 $21,931 $21,931
Bad-Case NPV −$4,723
Decline in NPV $40,996
POI 1
NTS:

FIC
ULT
Y:
QUE Multiple Choice
STIO
N TY
PE:

HAS False
VARI
ABL
ES:
LEA FMTP.EHRH.20.11.05 - LO: 11-5
RNI
NG
OBJ
ECTI
VES:

ONA
L ST
AND
ARD
S:
TAN flows
DAR
DS:
AL S
TAN
DAR
DS:
TOP Sensitivity analysis
ICS:
WOR
DS:
ER:
DAT 8/9/2018 11:04 AM
E C
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DAT 1/27/2019 8:59 PM
E M
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71. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is
a standardized measure of the risk per unit of expected return.
a. True
b. Fals
e
ANSWER: True
POINTS: 1
72. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the
securities being compared differ significantly.
a. True
b. Fals
e
ANSWER: False
POINTS: 1
TOPICS: CV vs. SD
73. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of
30%. What is the project's coefficient of variation?
a. 1.20
b. 1.26
c. 1.32
d. 1.39
e. 1.46
ANSWER: a
RATIONALE: Expected return 25.0%
Standard deviation 30.0%
Coefficient of variation = Std dev/Expected return = 1.20

POINTS: 1
LEARNING OBJECTIV FMTP.EHRH.20.11.06 - LO: 11-6
ES:
NATIONAL STANDARD United States - BUSPROG: Analytic
S:
74. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What
is the investment's coefficient of variation?
a. 0.67
b. 0.73
c. 0.81
d. 0.89
e. 0.98
ANSWER: a
RATIONALE: Expected return 15.0%
Standard deviation 10.0%
Coefficient of variation = Std dev/Expected return = 0.67
POINTS: 1
LEARNING OBJECTIV FMTP.EHRH.20.11.06 - LO: 11-6
ES:
NATIONAL STANDARD United States - BUSPROG: Analytic
S:

a. 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.
b Well-diversified stockholders do not need to consider market risk when determining
. required rates of return.
c. Market risk is important, but it does not have a direct effect on stock prices because it
only affects beta.
d Simulation analysis is a computerized version of scenario analysis where input
. variables are selected randomly on the basis of their probability distributions.
e. Sensitivity analysis is a good way to measure market risk because it explicitly takes
into account diversification effects.
ANSWER: d
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Sensitivity, scenario, & sim.

a. 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.
b 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.
c. 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.
d As computer technology advances, simulation analysis becomes increasingly obsolete
. and thus less likely to be used as compared to sensitivity analysis.
e. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider
the probability of occurrence of the key input variables.
ANSWER: e
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Sensitivity, scenario, & sim.
77. Which of the following procedures does the text say is used most frequently by businesses when they do capital
budgeting analyses?
a. Differential project risk cannot be accounted for by using "risk-adjusted discount
rates" because it is highly subjective and difficult to justify. It is better to not risk
adjust at all.
b Other things held constant, if returns on a project are thought to be positively
. correlated with the returns on other firms in the economy, then the project's NPV will
be found using a lower discount rate than would be appropriate if the project's returns
were negatively correlated.
c. Monte Carlo simulation uses a computer to generate random sets of inputs, those
inputs are then used to determine a trial NPV, and a number of trial NPVs are
averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the
other hand, require much more information regarding the input variables, including
probability distributions and correlations among those variables. This makes it easier
to implement a simulation analysis than a scenario or a sensitivity analysis, hence
simulation is the most frequently used procedure.
d DCF techniques were originally developed to value passive investments (stocks and
. bonds). However, capital budgeting projects are not passive investments⎯managers
can often take positive actions after the investment has been made that alter the cash
flow stream. Opportunities for such actions are called real options. Real options are
valuable, but this value is not captured by conventional NPV analysis. Therefore, a
project's real options must be considered separately.
e. The firm's corporate, or overall, WACC is used to discount all project cash flows to
find the projects' NPVs. Then, depending on how risky different projects are judged to
be, the calculated NPVs are scaled up or down to adjust for differential risk.
ANSWER: d
POINTS: 1
TIVES:
ARDS:
S:
TOPICS: Risk adjustment
78. Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple
decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease
operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a
payment to those parties. How much is the option to abandon worth to the firm?
a. $55.08
b. $57.98
c. $61.03
d. $64.08
e. $67.29
ANSWER: c
RATIONALE:
POINTS: 1
DIFFICULTY Difficulty: Challenging
:
YPE:
HAS VARIAB False

LES:
BJECTIVES:
TANDARDS:
STATE STAN United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of
DARDS: capital
DARDS:
TOPICS: Phased decision
DATE CREAT 8/9/2018 11:04 AM
ED:
DATE MODI 8/9/2018 11:04 AM
FIED:

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Chapter 11: Cash Flow Estimation and Risk Analysis

17. Which of the following statements is CORRECT?

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18. Which of the following statements is CORRECT?

19. Which of the following statements is CORRECT?

20. Which of the following statements is CORRECT?

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

28. Which of the following statements is CORRECT?

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31. Which of the following statements is CORRECT?

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40. Which of the following statements is CORRECT?

41. Which of the following statements is CORRECT?

42. Which of the following statements is CORRECT?

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44. Which of the following statements is CORRECT?

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Project cost of capital (r) 10.0%

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Which of the following statements is CORRECT?

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75. Which of the following statements is CORRECT?

76. Which of the following statements is CORRECT?

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