Corporate Finance A Focused Approach 5th Edition Ehrhardt Test Bank

Corporate Finance A Focused
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CHAPTER 11—CASH FLOW ESTIMATION AND RISK ANALYSIS
TRUE/FALSE
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.
ANS: F PTS: 1 DIF: Difficulty: Easy

OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking
STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting,
and cash flows LOC: TBA TOP: Cash flow estimation
KEY: Bloom’s: Knowledge
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.
ANS: T PTS: 1 DIF: Difficulty: Easy

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.

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.

and cash flows LOC: TBA TOP: Relevant cash flows
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.

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website, in whole or in part.
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.

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.

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.

STA: DISC: Capital budgeting and cost of capital LOC: TBA
TOP: Externalities KEY: Bloom’s: Knowledge
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.

TOP: Externalities KEY: Bloom’s: Knowledge
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.
ANS: F
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.
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1

NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital
LOC: TBA TOP: Externalities KEY: Bloom’s: Knowledge
11. 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.
TOP: Changes in NWC KEY: Bloom’s: Knowledge
12. 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.

and cash flows LOC: TBA TOP: Depreciation cash flows
13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

and cash flows LOC: TBA TOP: Risk-adjusted discount rate
18. 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.

OBJ: LO: 11-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return
LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Knowledge
19. 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.

LOC: TBA TOP: CV vs. SD KEY: Bloom’s: Knowledge
20. 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.
ANS: F PTS: 1 DIF: Difficulty: Moderate

KEY: Bloom’s: Comprehension
21. 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.
ANS: T PTS: 1 DIF: Difficulty: Moderate

22. 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.

23. 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.

TOP: Opportunity costs KEY: Bloom’s: Comprehension
24. 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.

TOP: Sunk costs KEY: Bloom’s: Comprehension
25. 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.

TOP: Net working capital KEY: Bloom’s: Comprehension
26. 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.

27. 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.

TOP: Sensitivity analysis KEY: Bloom’s: Comprehension
28. 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.
LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Comprehension
MULTIPLE CHOICE
29. 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.
ANS: D PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 11-1 NAT: BUSPROG: Analytic
and cash flows LOC: TBA TOP: Cash flow issues
KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual
30. 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.
ANS: E PTS: 1 DIF: Difficulty: Easy
TOP: Risk adjustment KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual
31. Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a WACC 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%.
ANS: A PTS: 1 DIF: Difficulty: Easy
TOP: Risk-adjusted discount rate KEY: Bloom’s: Comprehension
32. 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.
ANS: B PTS: 1 DIF: Difficulty: Easy

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.
ANS: C PTS: 1 DIF: Difficulty: Easy

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.
ANS: A PTS: 1 DIF: Difficulty: Moderate
TOP: Externalities KEY: Bloom’s: Comprehension

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.
ANS: D PTS: 1 DIF: Difficulty: Moderate
TOP: Externalities KEY: Bloom’s: Analysis

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.
ANS: E PTS: 1 DIF: Difficulty: Moderate
TOP: Depreciation KEY: Bloom’s: Analysis

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.
ANS: C PTS: 1 DIF: Difficulty: Moderate

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.
39. 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.
KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual
40. 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.
ANS: B PTS: 1 DIF: Difficulty: Moderate
41. 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.
42. 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.
43. 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%.
44. 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.
ANS: B PTS: 1 DIF: Difficulty: Moderate
45. 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.

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.
ANS: C
Regarding e and a, note that since interest should not be considered, exclusion will not lead to any type
of bias, positive or negative.
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1

NAT: BUSPROG: Analytic
47. 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.
and cash flows LOC: TBA TOP: Incremental cash flows
48. 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.
and cash flows LOC: TBA TOP: Incremental cash flows

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.
TOP: Externalities KEY: Bloom’s: Analysis
50. 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 WACC 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
WACC. If interest were deducted when estimating cash flows, this would, in effect,
"double count" it.
and cash flows LOC: TBA TOP: New project cash flows
51. 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 (NPV) $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.
ANS: B
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.

NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital
LOC: TBA TOP: Risk analysis KEY: Bloom’s: Analysis
52. 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.
ANS: E
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.

LOC: TBA TOP: Risk analysis KEY: Bloom’s: Analysis
53. 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.
TOP: Project's effect on firm risk KEY: Bloom’s: Analysis
54. 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 WACC 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.
ANS: C
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

LOC: TBA TOP: Risk-adjusted discount rate KEY: Bloom’s: Analysis

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.
TOP: Sensitivity, scenario, & sim. KEY: Bloom’s: Analysis

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.
TOP: Sensitivity, scenario, & sim. KEY: Bloom’s: Analysis
57. 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.
TOP: Risk adjustment KEY: Bloom’s: Analysis

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.
and cash flows LOC: TBA
TOP: CFs and accounting measures KEY: Bloom’s: Analysis
59. 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 35.0%
a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568
ANS: A
− Operating costs (excl. deprec.) 6,000
− Depreciation 4,000
Operating income (EBIT) $ 3,000
− Taxes Rate = 35% 1,050
After-tax EBIT $ 1,950
+ Depreciation 4,000
Cash flow, Year 1 $ 5,950

and cash flows LOC: TBA TOP: Annual CF
KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem
NOT: 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.
60. 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 35.0%
a. $8,903
b. $9,179
c. $9,463
d. $9,746
e. $10,039
ANS: C
Operating income (EBIT) $ 2,250
− Taxes Rate = 35% 788
Cash flow, Year 1 $ 9,463

61. 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 35.0%
a. $28,115
b. $28,836
c. $29,575
d. $30,333
e. $31,092
ANS: D
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 = 35.0% 4,667
Cash flow, Year 1 $30,333

62. 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 35.0%
a. $16,351
b. $17,212
c. $18,118
d. $19,071
e. $20,075
ANS: E
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 = 35% 5,425
After-tax EBIT $10,075

63. 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 35.0%
a. $25,816
b. $27,175
c. $28,534
d. $29,960
e. $31,458
ANS: B
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 = 35% 10,325
After-tax EBIT $19,175

64. 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
ANS: A
Expected return 25.0%
Standard deviation 30.0%
Coefficient of variation = Std dev/Expected return = 1.20

NAT: BUSPROG: Analytic STA: DISC: Risk and return
LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Application
MSC: TYPE: Multiple Choice: Problem
65. 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
ANS: A
Expected return 15.0%
Standard deviation 10.0%
Coefficient of variation = Std dev/Expected return = 0.67

NAT: BUSPROG: Analytic STA: DISC: Risk and return
LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Application
66. 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 35.0%
a. $30,333
b. $31,849
c. $33,442
d. $35,114
e. $36,869
ANS: A
Depreciation rate 33.33%

− Taxes Rate = 35% 4,667

and cash flows LOC: TBA TOP: Annual CF | MACRS
KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem
67. 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 35.0%
a. $11,904
b. $12,531
c. $13,190
d. $13,850
e. $14,542
ANS: C
Depreciation rate, Year 4 7.41%

− Taxes Rate = 35% 4,310

and cash flows LOC: TBA TOP: Annual CF | MACRS
68. 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 WACC 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 35.0%
a. $15,740
b. $16,569
c. $17,441
d. $18,359
e. $19,325
ANS: E
WACC 10.0% Years 0 1 2 3
Investment cost −$65,000
Sales revenues $65,500 $65,500 $65,500
− Operating costs (excl. deprec.) 25,000 25,000 25,000
− Depreciation rate = 33.333% 21,667 21,667 21,667
Operating income (EBIT) $18,833 $18,833 $18,833
− Taxes Rate = 35% 6,592 6,592 6,592
After-tax EBIT $12,242 $12,242 $12,242
+ Depreciation 21,667 21,667 21,667
Cash flow −$65,000 $33,908 $33,908 $33,908
NPV $19,325

and cash flows LOC: TBA TOP: Project NPV
69. 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 40%. 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. $5,558
b. $5,850
c. $6,143
d. $6,450
e. $6,772
ANS: B
% depreciated on equip. 75%
Tax rate 40%

− Accumulated deprec. 16,875
Current book value of equipment $ 5,625
Market value of equipment 6,000
Gain (or loss): Market value − Book value $ 375
Taxes paid on gain (−) or credited (+) on loss −150
AT salvage value = market value +/− taxes $ 5,850

LOC: TBA TOP: Salvage value KEY: Bloom’s: Analysis
70. 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 40%, 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. $8,878
b. $9,345
c. $9,837
d. $10,355
e. $10,900
ANS: E
Deprec. Annual Year-end
Year Rate Basis Deprec. Book Value
1 0.20 $50,000 $10,000 $40,000
2 0.32 50,000 16,000 24,000
3 0.19 50,000 9,500 14,500
4 0.12 50,000 6,000 8,500
5 0.11 50,000 5,500 3,000
6 0.06 50,000 3,000 0
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 = 40% 1,600
AT salvage value = market value +/− taxes $10,900

LOC: TBA TOP: Salvage value KEY: Bloom’s: Analysis
71. 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.)
WACC 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 35.0%
a. $3,636
b. $3,828
c. $4,019
d. $4,220
e. $4,431
ANS: B
t=0 t=1 t=2 t=3
Investment (Basis) WACC = 10% −$80,000
Sales revenues $67,500 $67,500 $67,500
− Cannibalization cost 5,000 5,000 5,000
− Basis  rate = deprec. Rate = 33.33% 26,667 26,667 26,667
− Taxes Rate = 35% 3,792 3,792 3,792
After-tax EBIT $ 7,042 $ 7,042 $ 7,042
+ Depreciation 26,667 26,667 26,667
Cash flow −$80,000 $33,708 $33,708 $33,708
NPV $3,828
PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2

72. 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.)
WACC 10.0%
Opportunity cost $100,000
Net equipment cost (depreciable basis) $65,000
Straight-line deprec. rate for equipment 33.333%
Tax rate 35%
a. $10,521
b. $11,075
c. $11,658
d. $12,271
e. $12,885
ANS: D
t=0 t=1 t=2 t=3
Investment WACC = 10% −$ 65,000
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 = 35% 26,717 26,717 26,717
After-tax EBIT $ 49,617 $ 49,617 $ 49,617
+ Depreciation 21,667 21,667 21,667
Cash flow −$165,000 $ 71,283 $ 71,283 $ 71,283
NPV $12,271

73. 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.)
WACC 10.0%
Net investment in fixed assets (basis) $75,000
Required new working capital $15,000
Tax rate 35.0%
a. $23,852
b. $25,045
c. $26,297
d. $27,612
e. $28,993
ANS: A
t=0 t=1 t=2 t=3
Investment in fixed assets WACC = 10% −$75,000
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 = 35% 8,750 8,750 8,750
After-tax EBIT $16,250 $16,250 $16,250
+ Depreciation 25,000 25,000 25,000
Cash flow from operations −$90,000 $41,250 $41,250 $41,250
Recovery of working capital 15,000
Total cash flows −$90,000 $41,250 $41,250 $56,250
NPV $23,852

74. 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?
WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Expected pretax salvage value $5,000
Tax rate 35.0%
a. $20,762
b. $21,854
c. $23,005
d. $24,155
e. $25,363
ANS: C
t=0 t=1 t=2 t=3
Investment in fixed assets WACC = 10% −$70,000
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 = 35% 7,583 7,583 7,583
After-tax EBIT $14,083 $14,083 $14,083
+ Depreciation 23,333 23,333 23,333
Cash flow from operations −$80,000 $37,417 $37,417 $37,417
Recovery of working capital 10,000
Salvage value, pre-tax 5,000
− Tax on salvage value Rate = 35% 1,750
Total cash flows −$80,000 $37,417 $37,417 $50,667
NPV $23,005

75. 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?
WACC 10.0%
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 40.0%
a. $15,925
b. $16,764
c. $17,646
d. $18,528
e. $19,455
ANS: C
Base Case Calculations
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 = 40% 9,333 14,133 19,173
After-tax EBIT $ 14,000 $ 21,200 $ 28,760
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 80,667 $ 87,867 $ 95,427
NPV $17,646

and cash flows LOC: TBA TOP: NPV including inflation
76. 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?
WACC 10.0%
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 35.0%
a. $13,286
b. $13,985
c. $14,721
d. $15,457
e. $16,230
ANS: C
NPV with no adjustment
t=0 t=1 t=2 t=3
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 = 35% 8,167 8,167 8,167
After-tax EBIT $ 15,167 $ 15,167 $ 15,167
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 81,833 $ 81,833 $ 81,833
NPV w/o infl. adjustment $3,507
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 = 35% 8,167 11,527 15,021
After-tax EBIT $ 15,167 $ 21,407 $ 27,896
+ Depreciation 66,667 66,667 66,667
Cash flow −$200,000 $ 81,833 $ 88,073 $ 94,563
NPV w/infl. adjustment $18,228
Increase w/infl. adjustment $14,721

and cash flows LOC: TBA TOP: NPV including inflation
77. 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.)
WACC 10.0%
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 35.0%
a. $28,939
b. $30,462
c. $32,066
d. $33,753
e. $35,530
ANS: E
Base Case Calculations
t=0 t=1 t=2 t=3
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 = 35% 8,733 8,733 8,733
After-tax EBIT $16,218 $16,218 $16,218
+ Depreciation 20,000 20,000 20,000
Cash flow −$60,000 $36,218 $36,218 $36,218
Base-Case NPV $30,068
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 1,040 1,040 1,040
After-tax EBIT $1,931 $1,931 $1,931
+ Depreciation 20,000 20,000 20,000
Cash flow −$60,000 $21,931 $21,931 $21,931
Bad-Case NPV −$5,462
Decline in NPV $35,530

and cash flows LOC: TBA TOP: Sensitivity analysis
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
ANS: C

LOC: TBA TOP: Phased decision KEY: Bloom’s: Analysis

Corporate Finance A Focused Approach 5th Edition Ehrhardt Test Bank

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Corporate Finance A Focused Approach 5th Edition Ehrhardt Test Bank

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Corporate Finance A Focused

Approach 5th Edition Ehrhardt Test

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Easy

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: T PTS: 1 DIF: Difficulty: Moderate

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: T PTS: 1 DIF: Difficulty: Moderate

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: T PTS: 1 DIF: Difficulty: Moderate

32. Which of the following statements is CORRECT?

33. Which of the following statements is CORRECT?

34. Which of the following statements is CORRECT?

35. Which of the following statements is CORRECT?

36. Which of the following statements is CORRECT?

37. Which of the following statements is CORRECT?

38. Which of the following statements is CORRECT?

46. Which of the following statements is CORRECT?

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1

49. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3

Project Risk Expected Return

Which set of projects would maximize shareholder wealth?

Expected Req'd Return

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3

55. Which of the following statements is CORRECT?

56. Which of the following statements is CORRECT?

58. Which of the following statements is CORRECT?

Sales revenues $13,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2

Sales revenues $22,250

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2

Equipment cost (depreciable basis) $65,000

Sales revenues $60,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2

Sales revenues, each year $42,500

Sales revenues $42,500

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2

Sales revenues, each year $62,500

Sales revenues $62,500

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-6

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-6