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:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT: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:TPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT: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

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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT: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

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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows

KEY:Bloom’s: Knowledge

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.

ANS:TPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows

KEY:Bloom’s: Knowledge

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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows

KEY:Bloom’s: Knowledge

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.

ANS:TPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows

KEY:Bloom’s: Knowledge

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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital LOC: TBA

TOP:ExternalitiesKEY: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.

ANS:TPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-1NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital LOC: TBA

TOP:ExternalitiesKEY: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:TBATOP:ExternalitiesKEY: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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-2NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital LOC: TBA

TOP:Changes in NWCKEY: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.

ANS:FPTS:1DIF:Difficulty: Easy

OBJ:LO: 11-2NAT:BUSPROG: Reflective Thinking

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows

KEY:Bloom’s: Knowledge