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Exam 13: Cash Flow Estimation and Risk Analysis

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Question 1

True/False

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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) False

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Question 2

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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? $\begin{array} { c c } \text { Year } & \text { Depreciation Rate } \\\hline 1 & 0.20 \\2 & 0.32 \\3 & 0.19 \\4 & 0.12 \\5 & 0.11 \\6 & 0.06\end{array}$

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

F) C) and D)
G) B) and D)

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Question 3

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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? $\begin{array} { l r } \text { Sales revenues, each year) } & \$ 62,000 \\\text { Depreciation} & \$8,000\\\text { Other operating costs } & \$ 25,000 \\\text { Interest expense } & \$8,000 \\\text { Tax rate } & 35.0 \%\end{array}$

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?

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.

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

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.

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? $\begin{array} { l r } \text { Risk-adjusted WACC } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 65,000 \\\text { Straight-line deprec. rate } & 33.3333 \% \\\text { Sales revenues, each year } & \$ 65,500 \\\text { Operating costs (excl. deprec.) , each year } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$

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? $\begin{array} { l r } \text { WACC } & 10.0 \% \\\text { Net investment in fixed assets (depreciable basis) } & \$ 70,000 \\\text { Required new working capital } & \$ 10,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 30,000 \\\text { Expected pretax salvage value } & \$ 5,000 \\\text { Tax rate } & 35.0 \%\end{array}$

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?

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? $\begin{array} { l r } \text { Equipment cost (depreciable basis) } & \$ 65,000 \\\text { Straight-line depreciation rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 60,000 \\\text { Operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$

Which of the following statements is CORRECT?

Which of the following factors should be included in the cash flows used to estimate a project's NPV?

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?

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.

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.

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?

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.

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.

Which of the following statements is CORRECT?