Chapter 9

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Terms in this set (...)

In the context of capital budgeting, what does sensitivity analysis do?
It examines how sensitive a particular NPV calculation is to changes in underlying assumptions
An option on a real asset rather than a financial asset is known as a:
real option
managerial option
cash flows used in project estimation should always reflect:
after tax cash flows
cash flows when they occur
What is scenario analysis?
determines the impact on NPV of a set of events relating to a specific scenario
Incremental cash flows come about as a(n) ______ consequence of taking a project under consideration
direct
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
IRR
NPV
Payback Period
One of the most important steps in estimating cash flow is to determine the ____ cash flows
relevant
Which of the following are reasons why NPV is considered a superior capital budgeting technique
1. it considers the riskiness of the project.
2. it considers time value of money.
3. it considers all the cash flows.
4. it properly chooses among mutually exclusive projects (helps rank).
The primary risk in estimation errors is the potential to ________.
Make incorrect capital budgeting decisions.
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:
1. it determines the book value of assets which affects net salvage value
2. it determines taxes owed on fixed assets when they are sold
3. it affects a firm's annual tax liability
Which of the following are considered relevant cash flows?
-cash flows from beneficial spillover effects
-cash flows from opportunity costs
-cash flows from erosion effects
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?
the operating cash flows from net sales over the life of the project
If a firm's sales estimate used in its base case analysis is 1,000 units per year and they anticipate the upper and lower bounds to be +/- 15%, what is the "best case" for units sold per year?
1,150
Which of the following are fixed costs?
cost of equipment
rent on a production facility
According to the _____ principal, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm"
stand-alone
Capital rationing exists when a company has identified positive NPV projects but can't or won't find:
necessary financing
Which of the following are components of project cash flow?
1. operating cash flow
2. capital spending
3. change in net working capital
What is the key question to ask concerning a project that results in a positive NPV?
What is the underlying source of value?
When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:
- scenario analysis
- asking what-if questions
If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be
100% reversed
A manager has estimated a positive NPV for a project. What could drive this result?
- the project is a good investment
- the cash flow estimations are inaccurate
- overly optimistic management
The goals of risk analysis in capital budgeting include:
1. assessing the degree of financing risk
2. identifying critical components
The positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish?
Market Value
Opportunity costs are ______
benefits lost due to taking on a particular project.
Which of the following is the equation for estimating operating cash flows using the tax shield approach?
(sales-costs) x (1-Tc) + Depreciation x Tc
Broadband, Inc. has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.
$400,000
Synergy will _____ the sales of existing products
increase
What are the two main benefits of performing sensitivity analysis?
1. it reduces a false sense of security by giving a range of values for NPV instead of a single value
2. it identifies the variable that has the most effect on NPV.
T/F: While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time.
True
Investment in net working capital arises when ______
1. cash is kept for unexpected expenditures
2. credit sales are made
3. inventory is purchased
Sunk costs are costs that _____
have already occurred and are not affected by accepting or rejecting a project.
Which of the following statement regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
1. taxes are based on the difference between the book value and the sales price.
2. book value represents the purchase price minus the accumulated depreciation.
3. there will be a tax savings if the book value exceeds the sales price.
What are the two main drawbacks of sensitivity analysis?
1. it does not consider interaction among variable.
2. it may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.
The possibility that errors in projected cash flows will lead to incorrect decisions is known as:
1. forecasting risk
2. estimation risk
What is net working capital?
Current assets minus current liabilities
Interest expenses incurred on debt financing are ____ when computing cash flows from a project
ignored
West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ____ of the cash flow estimates.
Reliability
Accounts receivable and accounts payable are included in the project cash flow estimation as part of changes in ____.
Net working capital
What is the difference between scenario analysis and sensitivity analysis?
Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time.
What is an important drawback of traditional NPV analysis?
It ignores managerial options in investment decisions
What is the depreciation tax shield if EBIT is $600, depreciation is $1,800, and the tax rate is 30%
$540
Tax shield = $1800 x .3 = 540
In order to analyze the risk of the project's NPV estimate, we should establish _____ for each important estimate variable.
upper and lower bounds
Which of the following correctly describes the relationship between depreciation, income taxes, and investment cash flows?
As depreciation expense increases, net income and taxes will decrease, while investment cash flows will increase
Which of the following is an example of an opportunity cost
Rental income likely to be lost by using a vacant building for an upcoming project
A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:
cannot be observed
The company borrowed $500,000 at an interest rate of 10% to pursue the project. This is an example of what type of cash flow?
Financing expense
The equipment will be depreciated straight-line over the next five years. This is an example of what type of cash flow?
Depreciation
The company can sell land it currently owns or build a new factory. This is an example of what type of cash flow?
Opportunity cost
As a result of the project, sales on the existing air conditioners will decline by 10%. This is an example of what type of cash flow?
Erosion
The company spent $10 million in research and development costs on the new product. This is an example of what type of cash flow?
Sunk cost
The company will invest in inventory before the project is started. This is an example of what type of cash flow?
Net working capital
What types of cash flows should be included from the analysis of a project?
Depreciation
Opportunity Cost
Erosion
Net working capital
What types of cash flows should be excluded from the analysis of a project?
Financing expense
Sunk Cost