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Rowell 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. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?


A) 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.
B) 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.
C) This is an example of an externality, because the existence of the building affects the cash flows for any new project that Rowell might consider.
D) 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.
E) 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.

F) A) and D)
G) All of the above

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As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?


A) $5,950
B) $6,099
C) $6,251
D) $6,407
E) $6,568

F) D) and E)
G) A) and B)

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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) False

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Carlyle Inc. is considering two mutually exclusive projects. Both require an initial investment of $15,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $5,200 at the end of each of the next 4 years. Each project has a WACC of 9.00%, and neither can be repeated. The controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is selected over Project S, i.e., what is the value of NPVL - NPVS?


A) $262.74
B) $291.93
C) $324.37
D) $356.80
E) $392.48

F) A) and B)
G) D) and E)

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Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?


A) The new project is expected to reduce sales of one of the company's existing products by 5%.
B) 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.
C) The company has spent and expensed $1 million on R&D associated with the new project.
D) The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
E) 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.

F) A) and B)
G) All of the above

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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) False

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Which of the following statements is CORRECT?


A) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
B) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
C) 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.
D) 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.
E) 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.

F) B) and E)
G) All of the above

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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) False

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Which of the following statements is CORRECT?


A) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
B) 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.
C) 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.
D) Sunk costs were formerly
E) 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.

F) All of the above
G) A) and B)

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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) False

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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) False

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Which of the following statements is CORRECT?


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 competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
B) 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.
C) 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.
D) 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.
E) 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.

F) C) and D)
G) A) and D)

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Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. 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?


A) $8,878
B) $9,345
C) $9,837
D) $10,355
E) $10,900

F) A) and B)
G) A) and E)

Correct Answer

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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) False

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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) False

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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) False

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Suppose Tapley Inc. 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 Tapley accept, assuming that the company uses the NPV method when choosing projects?


A) Project A, which has average risk and an IRR = 9%.
B) Project B, which has below-average risk and an IRR = 8.5%.
C) Project C, which has above-average risk and an IRR = 11%.
D) Without information about the projects' NPVs we cannot determine which one or ones should be accepted.
E) All of these projects should be accepted.

F) B) and E)
G) A) and B)

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Which of the following statements is CORRECT?


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 an upward bias in the NPV.
B) 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.
C) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
D) 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 proceeds that could be obtained should be charged as a cost to the project under consideration.
E) 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.

F) C) and D)
G) A) and D)

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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) False

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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) False

Correct Answer

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