Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

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Question 25

  1. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

    Answer

    Changes in net working capital.
    Shipping and installation costs.
    Cannibalization effects.
    Opportunity costs.
    Sunk costs that have been expensed for tax purposes.

2 points

Question 26

  1. Which of the following statements is CORRECT?

    Answer

    Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
    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.
    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.
    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.
    As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.

2 points

Question 27

  1. 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?

    Answer

    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.
    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.
    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.
    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.
    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.

2 points

Question 28

  1. Which of the following statements is CORRECT?

    Answer

    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.
    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.
    The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.
    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.
    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.

2 points

Question 29

  1. Which of the following rules is CORRECT for capital budgeting analysis?

    Answer

    The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
    Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
    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.
    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.
    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.

2 points

Question 30

  1. 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?

    Answer

    Project A, which has average risk and an IRR = 9%.
    Project B, which has below-average risk and an IRR = 8.5%.
    Project C, which has above-average risk and an IRR = 11%.
    Without information about the projects’ NPVs we cannot determine which project(s) should be accepted.
    All of these projects should be accepted.
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