CASH FLOW ESTIMATION AND RISK ANALYSIS EXERCISE

CHAPTER 1

CHAPTER 13CASH FLOW ESTIMATION AND RISK ANALYSIS(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.Multiple Choice: True/False

(13-1) Cash flow estimationF I KAnswer: b EASY

.Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

a.True

b.False

(13-1) Cash flow estimationF I KAnswer: a EASY

.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.

a.True

b.False

(13-1) Cash flow estimationF I KAnswer: b EASY

.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.

a.True

b.False

(13-1) Relevant cash flowsF I KAnswer: b EASY

.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.

a.True

b.False

(13-1) Relevant cash flowsF I KAnswer: a EASY

.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(13-1) Relevant cash flowsF I KAnswer: b EASY

.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

(13-1) Relevant cash flowsF I KAnswer: a EASY

.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.

a.True

b.False

(13-1) ExternalitiesF IAnswer: b EASY

.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

(13-1) ExternalitiesF IAnswer: a EASY

.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

(13-1) ExternalitiesF IAnswer: b EASY

.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

(13-2) Changes in NOWCF IAnswer: b EASY

.Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital.

a.True

b.False

(13-2) Depreciation cash flowsF I KAnswer: b EASY

.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.

a.True

b.False

(13-2) Depreciation cash flowsF I KAnswer: a EASY

.The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.

a.True

b.False

(13-2) Depreciation cash flowsF I KAnswer: b EASY

.Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant.

a.True

b.False


.A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

a.True

b.False


.Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.

a.True

b.False

(13-4) Risk-adjusted discount rateF IAnswer: a EASY

.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

(13-1) Cash flow estimationF I KAnswer: b MEDIUM

.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 for capital budgeting projects.

a.True

b.False

(13-1) Cash flow estimationF I KAnswer: a MEDIUM

.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

(13-1) Relevant cash flowsF I KAnswer: b MEDIUM

.The two cardinal rules that financial analysts should follow to avoid 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 for capital budgeting projects.

a.True

b.False

(13-1) Opportunity costsF IAnswer: a MEDIUM

.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

(13-1) Sunk costsF IAnswer: b MEDIUM

.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

(13-2) NOWCF IAnswer: b MEDIUM

.The change in net operating working capital associated with new projects is always positive, because new projects mean that more operating working capital will be required.

a.True

b.False

(13-2) Depreciation cash flowsF I KAnswer: b MEDIUM

.The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

a.True

b.False

(13-5) Sensitivity analysisF IAnswer: a MEDIUM

.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

(13-7) Replacement chainF IAnswer: b MEDIUM

.Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.

a.True

b.False

(13-7) Replacement chainF IAnswer: b MEDIUM

.Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.a.True

b.False

(13-7) Common-life comparisonsF IAnswer: a MEDIUM

.Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their initial lives.

a.True

b.False

(13-7) Common life and EAAF IAnswer: a MEDIUM

.The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the equivalent annual annuity (EAA) approach.

a.True

b.False(13-7) Common life and EAAF IAnswer: b MEDIUM

.The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

a.True

b.False

Multiple Choice: Conceptual

(13-1) Cash flow issuesC I KAnswer: e EASY

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

a.Changes in net operating working capital.

b.Shipping and installation costs for machinery acquired.

c.Cannibalization effects.

d.Opportunity costs.

e.Sunk costs that have been expensed for tax purposes.

(13-4) Risk adjustmentC IAnswer: a EASY

.The relative risk of a proposed project is best accounted for by which of the following procedures?

a.Adjusting the discount rate upward if the project is judged to have above-average risk.

b.Adjusting the discount rate upward if the project is judged to have below-average risk.

c.Reducing the NPV by 10% for risky projects.

d.Picking a risk factor equal to the average discount rate.

e.Ignoring risk because project risk cannot be measured accurately.

(13-4) Risk and project selectionC IAnswer: b EASY

.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 as they will produce a positive NPV.

(13-1) Sunk costsC IAnswer: c EASY/MEDIUM

.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 hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the projects NPV.

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 firms existing stores.

(13-1) Sunk costsC IAnswer: d EASY/MEDIUM


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 banks 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 projects cash flows, then the projects calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.

(13-1) ExternalitiesC IAnswer: b EASY/MEDIUM


a.An externality is a situation where a project would have an adverse effect on some other part of the firms overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

b.An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the banks other offices to decline.

c.The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

d.Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

e.Identifying an externality can never lead to an increase in the calculated NPV.

(13-1) ExternalitiesC IAnswer: b EASY/MEDIUM


a.An externality is a situation where a project would have an adverse effect on some other part of the firms overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

b.An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the banks other offices to increase.

c.The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

d.Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

e.Identifying an externality can never lead to an increase in the calculated NPV.

(13-1) ExternalitiesC IAnswer: e EASY/MEDIUM


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.

(13-2) DepreciationC IAnswer: a EASY/MEDIUM


a.Using accelerated depreciation rather than straight line would normally have no effect on a projects total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

b.Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

c.Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.

d.Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.

e.Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

(13-2) DepreciationC IAnswer: d EASY/MEDIUM


a.Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.


c.Corporations must use the same depreciation method for both stockholder reporting and tax purposes.

d.Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a projects forecasted NPV.

e.Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a projects forecasted NPV.

(13-2) DepreciationC IAnswer: e EASY/MEDIUM


a.Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.


c.If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

d.If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

e.If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

(13-1) Relevant cash flowsC I KAnswer: c MEDIUM

.A company is considering a new project. The CFO plans to calculate the projects NPV by estimating the relevant cash flows for each year of the projects life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the companys overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

a.All sunk costs that have been incurred relating to the project.

b.All interest expenses on debt used to help finance the project.

c.The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the projects life.

d.Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.

e.Effects of the project on other divisions of the firm, but only if those effects lower the projects own direct cash flows.


.Which of the following factors should be included in the cash flows used to estimate a projects NPV?

a.All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

b.Interest on funds borrowed to help finance the project.

c.The end-of-project recovery of any additional net operating working capital required to operate the project.

d.Cannibalization effects, but only if those effects increase the projects projected cash flows.

e.Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

(13-1) Relevant cash flowsC I KAnswer: b MEDIUM

.When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

a.Changes in net operating working capital attributable to the project.

b.Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.

c.The value of a building owned by the firm that will be used for this project.

d.A decline in the sales of an existing product, provided that decline is directly attributable to this project.

e.The salvage value of assets used for the project that will be recovered at the end of the projects life.


.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 of the capital budgeting analysis 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 very 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.

(13-1) Relevant cash flowsC I KAnswer: a MEDIUM

.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 companys existing products by 5%.

b.Since the firms 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 projects initial cost.

c.The company has spent and expensed $1 million on research and development costs 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.


.Dalrymple Inc. is considering production of 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?

a.The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

b.The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment.

c.The company has spent and expensed for tax purposes $3 million on research related to the new product. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.

d.The new product will cut into sales of some of the firms other products.

e.If the project is accepted, the company must invest an additional $2 million in net operating working capital. However, all of these funds will be recovered at the end of the projects life.


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

a.The interest paid on funds borrowed to finance a project must be included in estimates of the projects cash flows.

b.Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.

c.Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the projects other costs when reaching the accept/reject decision.

d.A proposed projects estimated net income as determined by the firms accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the projects cost, the project should be accepted.

e.If a product is competitive with some of the firms 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 firms other products, this fact need not be reflected in the analysis.(13-1) Relevant cash flowsC I KAnswer: d MEDIUM


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 projects 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 projects 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.

(13-1) Incremental cash flowsC I KAnswer: d MEDIUM

.Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

a.A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

b.A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firms current products.

c.A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.

d.A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

e.A firm can produce a new product, and the existence of that product will stimulate sales of some of the firms other products.

(13-1) Incremental cash flowsC I KAnswer: d MEDIUM

.Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

a.Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

b.Revenues from an existing product would be lost as a result of customers switching to the new product.

c.Shipping and installation costs associated with a machine that would be used to produce the new product.

d.The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.

e.It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

(13-2) New project cash flowsC I KAnswer: a MEDIUM

.A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

a.In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, double count it.

b.Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.

c.When estimating the projects operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.

d.Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis.

e.The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.(13-4) Risk analysisC IAnswer: c MEDIUM

.Taussig Technologies is considering two potential projects, X and Y. In assessing the projects risks, the company estimated the beta of each project versus both the companys other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data:

Project X

Project Y

Expected NPV$350,000$350,000

Standard deviation (NPV)$100,000$150,000

Project beta (vs. market) 1.4 0.8

Correlation of the project cash flows with cash flows from currently existing projectsCash flows are not correlated with the cash flows from existing projectsCash flows are highly correlated with the cash flows from existing projects

Which of the following statements is CORRECT?

a.Project X has more stand-alone risk than Project Y.

b.Project X has more corporate (or within-firm) risk than Project Y.

c.Project X has more market risk than Project Y.

d.Project X has the same level of corporate risk as Project Y.

e.Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.

(13-4) Risk analysisC IAnswer: a MEDIUM

.Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new projects sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?

a.The proposed new project would have more stand-alone risk than the firms typical project.

b.The proposed new project would increase the firms corporate risk.

c.The proposed new project would increase the firms market risk.

d.The proposed new project would not affect the firms risk at all.

e.The proposed new project would have less stand-alone risk than the firms typical project.

(13-4) Project's effect on firm riskC IAnswer: e MEDIUM

.A firm is considering a new project whose risk is greater than the risk of the firms average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?

a.Increase the estimated IRR of the project to reflect its greater risk.

b.Increase the estimated NPV of the project to reflect its greater risk.

c.Reject the project, since its acceptance would increase the firms risk.

d.Ignore the risk differential if the project would amount to only a small fraction of the firms total assets.

e.Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

(13-5) Risk techniquesC IAnswer: e MEDIUM


a.Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

b.One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.

c.Well-diversified stockholders do not need to consider market risk when determining required rates of return.

d.Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.

e.Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

(13-5) Risk techniquesC IAnswer: a MEDIUM


a.Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

b.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 projects NPV.

c.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.

d.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.

e.As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

(Comp.) CFs and accounting measuresC I KAnswer: d MEDIUM


a.If an asset is sold for less than its book value at the end of a projects life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

b.Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.

c.It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the projects completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a projects life.

d.If equipment is expected to be sold for more than its book value at the end of a projects life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.

e.Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.Multiple Choice: ProblemsWe designated many of these questions EASY or MEDIUM. This indicates that they are not conceptually hard. However, some of them require a good bit of arithmetic, which will lengthen the time it takes students to work them. We tried to use constant cash flows, straight-line depreciation (except where we wanted to illustrate accelerated depreciation), and short project lives, but completing the cash flow estimation process still requires a good bit of arithmetic. This should not be important for take-home tests, but it should be considered when making up timed tests.(13-2) Annual CFC I KAnswer: a EASY

.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?

Sales revenues$13,000

Depreciation$4,000

Other operating costs$6,000

Tax rate35.0%

a.$5,950

b.$6,099

c.$6,251

d.$6,407

e.$6,568

(13-2) Annual CFC I KAnswer: c EASY

.Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow?


Depreciation$8,000

Other operating costs$12,000

Tax rate35.0%

a.$ 8,903

b.$ 9,179

c.$ 9,463

d.$ 9,746

e.$10,039

(13-2) Annual CFC I KAnswer: d EASY

.Clemson Software 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?

Equipment cost (depreciable basis)$65,000Straight-line depreciation rate33.333%

Sales revenues, each year$60,000

Operating costs (excl. depreciation)$25,000

Tax rate35.0%

a.$28,115b.$28,836c.$29,575d.$30,333e.$31,092(13-2) Annual CFC I KAnswer: e EASY/MEDIUM

.As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow?

Sales revenues, each year$42,500Depreciation$10,000

Other operating costs $17,000

Interest expense$4,000

Tax rate35.0%

a.$16,351

b.$17,212

c.$18,118

d.$19,071

e.$20,075

(13-2) Annual CFC I KAnswer: b EASY/MEDIUM

.You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow?


Depreciation$8,000

Other operating costs $25,000

Interest expense$8,000

Tax rate35.0%

a.$25,816

b.$27,175

c.$28,534

d.$29,960

e.$31,458

(13-2) Annual CF; MACRSC I KAnswer: a EASY/MEDIUM

.Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost (depreciable basis)$65,000



Tax rate35.0%

a.$30,258

b.$31,770

c.$33,359

d.$35,027

e.$36,778

(13-2) Annual CF; MACRSC I KAnswer: c MEDIUM

.Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

Equipment cost (depreciable basis)$70,000



Tax rate35.0%

a.$11,814

b.$12,436

c.$13,090

d.$13,745

e.$14,432

(13-2) Project NPVC I KAnswer: e MEDIUM

.Temple Corp. 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 change in net operating 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?Risk-adjusted WACC10.0%

Net investment cost (depreciable basis)$65,000

Straight-line depreciation rate33.3333%


Annual operating costs (excl. depreciation)$25,000

Tax rate35.0%

a.$15,740

b.$16,569

c.$17,441

d.$18,359

e.$19,325

(13-2) Salvage valueC IAnswer: b MEDIUM

.Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipments after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale.

a.$5,558

b.$5,850

c.$6,143

d.$6,450

e.$6,772

(13-2) Salvage valueC IAnswer: e MEDIUM

.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 depreciation rates below. 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?

YearDepreciation Rate

10.20

20.32

30.19

40.12

50.11

60.06

a.$ 8,878

b.$ 9,345

c.$ 9,837

d.$10,355e.$10,900(13-7) Replacement chain approachC IAnswer: d MEDIUM

.Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,900 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project?a.$4,242

b.$4,246

c.$4,286

d.$4,325

e.$4,433

(13-7) Equivalent annual annuityC IAnswer: d MEDIUM

.Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual annuity of the most profitable project?

a.$1,345.50

b.$1,346.30

c.$1,361.52

d.$1,376.74

e.$1,411.15

(13-7) Equivalent annual annuityC IAnswer: c MEDIUM

.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. In addition, Project S can be repeated at the end of Year 2 with no changes in its cash flows. Project L has an expected life of 4 years with after-tax cash inflows of $5,200 at the end of each of the next 4 years. Each project has a WACC of 9.00%. What is the equivalent annual annuity of the most profitable project?a.$ 569.97b.$ 782.34c.$ 865.31d.$1,522.18e.$1,846.54(13-2) Project NPVC I KAnswer: b MEDIUM/HARD

.TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no change in net operating working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC10.0%

Pre-tax cash flow reduction for other products (cannibalization)-$5,000Investment cost (depreciable basis)$80,000


Annual sales revenues$67,500

Annual operating costs (excl. depreciation)-$25,000

Tax rate35.0%

a.$3,636

b.$3,828

c.$4,019

d.$4,220

e.$4,431

(13-2) Project NPVC I KAnswer: d MEDIUM/HARD

.Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No change in net operating working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC10.0%Opportunity cost$100,000

Net equipment cost (depreciable basis)$65,000

Straight-line depreciation rate for equipment33.333%



Tax rate35%

a.$10,521

b.$11,075

c.$11,658

d.$12,271

e.$12,885

(13-7) Replacement chain approachC IAnswer: a MEDIUM/HARD

.Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next 4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. 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 ProjectS, i.e., what is the value of NPVL - NPVS?

a.$56.50

b.$62.15

c.$68.37

d.$75.21

e.$82.73

(13-2) NPV including inflationC I KAnswer: c HARD

.Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV?

WACC10.0%


Units sold50,000

Average price per unit, Year 1$25.00

Fixed oper. costs excl. depreciation (constant)$150,000Variable oper. cost/unit, Year 1 $20.20

Annual depreciation rate33.333%

Expected inflation rate per year5.00%

Tax rate40.0%

a.$15,925

b.$16,764

c.$17,646

d.$18,528

e.$19,455

(13-2) NPV including inflationC I KAnswer: c HARD

.Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made?

WACC10.0%


Units sold50,000

Average price per unit, Year 1$25.00

Fixed oper. costs excl. depreciation (constant)$150,000

Variable oper. cost/unit, Year 1$20.20

Annual depreciation rate33.333%

Expected inflation4.00%

Tax rate40.0%

a.$12,018

b.$12,650

c.$13,316

d.$13,982

e.$14,681

(13-2) Project NPVC I KAnswer: a HARD

.Foley Systems is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require additional net operating working capital that 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 life. What is the project's NPV? (Hint: Cash flows from operations are constant in Years 1 to 3.)

WACC10.0%

Net investment in fixed assets (basis)$75,000

Required net operating working capital$15,000




Tax rate35.0%

a.$23,852

b.$25,045

c.$26,297

d.$27,612

e.$28,993

(13-2) Project NPVC I KAnswer: c HARD

.Thomson Media 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, additional net operating 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?WACC10.0%

Net investment in fixed assets (depreciable basis)$70,000

Required net operating working capital$10,000




Expected pre-tax salvage value$5,000

Tax rate35.0%

a.$20,762

b.$21,854

c.$23,005

d.$24,155

e.$25,363

(13-5) Sensitivity analysisC I KAnswer: e HARD

.Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No change in net operating working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)

WACC10.0%


Number of cars washed2,800

Average price per car$25.00

Fixed oper. costs (excl. depreciation)$10,000

Variable oper. cost/unit (i.e., VC per car washed)$5.375

Annual depreciation$20,000

Tax rate35.0%

a.-$28,939

b.-$30,462

c.-$32,066

d.-$33,753

e.-$35,530APPENDIX 13ATAX DEPRECIATION(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.Multiple Choice: Conceptual

(13A) NPV and depreciationC IAnswer: a EASY/MEDIUM

.Other things held constant, which of the following would increase the NPV of a project being considered?

a.A shift from straight-line to MACRS depreciation.

b.Making the initial investment in the first year rather than spreading it over the first three years.

c.An increase in the discount rate associated with the project.

d.An increase in required net operating working capital.

e.The project would decrease sales of another product line.

(13A) Depreciation cash flowsC IAnswer: c MEDIUM

.Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce

a.Higher depreciation charges in the early years of an assets life.

b.Larger cash flows in the earlier years of an assets life.

c.Larger total undiscounted profits from the project over the projects life.

d.Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes.

e.Lower tax payments in the earlier years of an assets life.

CHAPTER 13ANSWERS AND SOLUTIONS

.(13-1) Cash flow estimationF I KAnswer: b EASY

.(13-1) Cash flow estimationF I KAnswer: a EASY

.(13-1) Cash flow estimationF I KAnswer: b EASY

.(13-1) Relevant cash flowsF I KAnswer: b EASY

.(13-1) Relevant cash flowsF I KAnswer: a EASY

.(13-1) Relevant cash flowsF I KAnswer: b EASY

.(13-1) Relevant cash flowsF I KAnswer: a EASY

.(13-1) ExternalitiesF IAnswer: b EASY

.(13-1) ExternalitiesF IAnswer: a EASY

.(13-1) ExternalitiesF IAnswer: b EASY

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 its possible effects.

.(13-2) Changes in NOWCF IAnswer: b EASY

.(13-2) Depreciation cash flowsF I KAnswer: b EASY

.(13-2) Depreciation cash flowsF I KAnswer: a EASY

.(13-2) Depreciation cash flowsF I KAnswer: b EASY



.(13-4) Risk-adjusted discount rateF IAnswer: a EASY

.(13-1) Cash flow estimationF I KAnswer: b MEDIUM

.(13-1) Cash flow estimationF I KAnswer: a MEDIUM

.(13-1) Relevant cash flowsF I KAnswer: b MEDIUM

.(13-1) Opportunity costsF IAnswer: a MEDIUM

.(13-1) Sunk costsF IAnswer: b MEDIUM

.(13-2) NOWCF IAnswer: b MEDIUM

.(13-2) Depreciation cash flowsF I KAnswer: b MEDIUM

.(13-5) Sensitivity analysisF IAnswer: a MEDIUM

.(13-7) Replacement chainF IAnswer: b MEDIUM

.(13-7) Replacement chainF IAnswer: b MEDIUM

.(13-7) Common-life comparisonsF IAnswer: a MEDIUM

.(13-7) Common life and EAAF IAnswer: a MEDIUM

.(13-7) Common life and EAAF IAnswer: b MEDIUM

.(13-1) Cash flow issuesC I KAnswer: e EASY

.(13-4) Risk adjustmentC IAnswer: a EASY

.(13-4) Risk and project selectionC IAnswer: b EASY

.(13-1) Sunk costsC IAnswer: c EASY/MEDIUM

.(13-1) Sunk costsC IAnswer: d EASY/MEDIUM

.(13-1) ExternalitiesC IAnswer: b EASY/MEDIUM

.(13-1) ExternalitiesC IAnswer: b EASY/MEDIUM

.(13-1) ExternalitiesC IAnswer: e EASY/MEDIUM

.(13-2) DepreciationC IAnswer: a EASY/MEDIUM

.(13-2) DepreciationC IAnswer: d EASY/MEDIUM

.(13-2) DepreciationC IAnswer: e EASY/MEDIUM

.(13-1) Relevant cash flowsC I KAnswer: c MEDIUM


.(13-1) Relevant cash flowsC I KAnswer: b MEDIUM


.(13-1) Relevant cash flowsC I KAnswer: a MEDIUM



.(13-1) Relevant cash flowsC I KAnswer: d MEDIUM

Regarding a and b, note that since interest should not be considered, exclusion will not lead to any type of bias, positive or negative.

.(13-1) Incremental cash flowsC I KAnswer: d MEDIUM

.(13-1) Incremental cash flowsC I KAnswer: d MEDIUM

.(13-2) New project cash flowsC I KAnswer: a MEDIUM

.(13-4) Risk analysisC IAnswer: c MEDIUM

Statement c is true, while the other statements are false. Stand-alone risk is measured by standard deviation. Therefore, since Ys standard deviation is higher than Xs, Y has higher stand-alone risk than X. Statement b is false because corporate risk is affected by the correlation of project cash flows with other company cash flows, and since Ys cash flows are more highly correlated with the cash flows of existing projects than Xs, Y has more corporate risk than X. Market risk is measured by beta. Therefore, since Xs beta is greater than Ys, statement c is true.

.(13-4) Risk analysisC IAnswer: a MEDIUM

Statement a is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other firms' revenues; hence, its within-firm and market risks would be relatively low.

.(13-4) Project's effect on firm riskC IAnswer: e MEDIUM

.(13-5) Risk techniquesC IAnswer: e MEDIUM

.(13-5) Risk techniquesC IAnswer: a MEDIUM

.(Comp.) CFs and accounting measuresC I KAnswer: d MEDIUM

.(12-2) Annual CFC I KAnswer: a EASY


Operating costs (excl. deprec.)6,000

Depreciation 4,000

Operating income (EBIT)$ 3,000

TaxesRate = 35% 1,050

EBIT(1 T)$ 1,950

+ Depreciation 4,000

Cash flow, Year 1$ 5,950

.(13-2) Annual CFC I KAnswer: c EASY



Depreciation 8,000

Operating income (EBIT)$ 2,250

TaxesRate = 35% 788

EBIT(1 T)$ 1,463


Cash flow, Year 1$ 9,463

.(13-2) Annual CFC I KAnswer: d EASY

Equipment life, years 3

Equipment cost $65,000

Depreciation:rate = 33.333%$21,667


Basis x rate = depreciation 21,667

Operating costs (excl. deprec.) 25,000

Operating income (EBIT)$13,333

TaxesRate = 35.0% 4,667

EBIT(1 T)$ 8,667


Cash flow, Year 1$30,333

.(13-2) Annual CFC I KAnswer: e EASY/MEDIUM

This problem is a bit harder than some of the earlier ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the calculation of cash flows since they will be discounted at the WACC in determining a projects NPV.



Depreciation 10,000



EBIT(1 T)$10,075



.(13-2) Annual CFC I KAnswer: b EASY/MEDIUM

This problem is a bit harder than some of the earlier ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.



Depreciation 8,000



EBIT(1 T)$19,175



.(13-2) Annual CF; MACRSC I KAnswer: a EASY/MEDIUM

Equipment cost$65,000

Depreciation rate33.0%



Depreciation 21,450



EBIT(1 T)$ 8,808



.(13-2) Annual CF; MACRSC I KAnswer: c MEDIUM


Depreciation rate, Year 47.0%



Depreciation 4,900



EBIT(1 T)$ 8,190



.(13-2) Project NPVC I KAnswer: e MEDIUM

WACC10.0%Years0123

Investment cost-$65,000

Sales revenues$65,500$65,500$65,500

Operating costs (excl. deprec.)25,00025,00025,000

Depreciation rate = 33.333% 21,667 21,667 21,667

Operating income (EBIT)$18,833$18,833$18,833

TaxesRate = 35% 6,592 6,592 6,592

EBIT(1 T)$12,242$12,242$12,242

+ Depreciation 21,667 21,667 21,667

Project CFs-$65,000$33,908$33,908$33,908

NPV$19,325

.(13-2) Salvage valueC IAnswer: b MEDIUM

% depreciated on equip.75%

Tax rate40%


Accumulated deprec. 16,875

Current book value of equipment$ 5,625

Market value of equipment 6,000

Gain (or loss): Market value Book value$ 375

Taxes paid on gain () or credited (+) on loss -150

AT salvage value = market value +/ taxes$ 5,850

.(13-2) Salvage valueC IAnswer: e MEDIUM

Deprec.AnnualYear-end

YearRateBasisDeprec.Book Value

10.20$50,000$10,000$40,000

20.3250,00016,00024,000

30.1950,0009,50014,500

40.1250,0006,0008,500

50.1150,0005,5003,000

60.0650,000 3,0000

1.00$50,000

Gross sales proceeds$12,500

Book value, end of Year 4 8,500

Profit$ 4,000

Tax on profitRate = 40% 1,600

AT salvage value = market value +/ taxes$10,900

.(13-7) Replacement chain approachC IAnswer: d MEDIUM

WACC = 8.00%

01234

Project X CFs-10,0006,0007,900

Extended CFs-10,0006,0007,900

Total Project X CFs-10,0006,000 -2,1006,0007,900

Project X, extended NPV = $4,324.87

01234

Project Y CFs-10,0004,3004,3004,3004,300

Project Y, NPV = $4,242.15

NPV of most profitable project, Project X = $4,324.87 $4,325.

.(13-7) Equivalent annual annuityC IAnswer: d MEDIUM

WACC = 11.00%

012

Project X CFs-10,0006,0008,500

Project X, NPV = $2,304.20

Determine Project X EAA:

N2

I/YR11.00%

PV$2,304.20

FV0

PMT = EAAX$1,345.50

01234

Project Y CFs-10,0004,6004,6004,6004,600

Project Y, NPV = $4,271.25

Determine Project Y EAA:

N4

I/YR11.00%

PV$4,271.25

FV0

PMT = EAAY$1,376.74

EAA of most profitable project, Project Y = $1,376.74

.(13-7) Equivalent annual annuityC IAnswer: c MEDIUM

WACC = 9.00%

Project S:012

CFs-$15,000$7,000$12,000

NPVS$1,522.18

EAAS:Enter the following inputs in your financial calculator:

N = 2; I/YR = 9; PV = -1522.18; FV = 0; and solve for PMT = EAA = $865.31.

Project L:01234

CFs-$15,000$5,200$5,200$5,200$5,200

NPVL$1,846.54

EAAL:Enter the following inputs in your financial calculator:

N = 4; I/YR = 9; PV = -1846.54; FV = 0; and solve for PMT = EAA = $569.97.

The most profitable project is the one with the higher EAA. Since EAAS > EAAL, choose Project S with EAA = $865.31.

.(13-2) Project NPVC I KAnswer: b MEDIUM/HARD

t = 0t = 1t = 2t = 3

Investment (Basis)WACC = 10%$80,000

Sales revenues$67,500$67,500$67,500

Cannibalization cost-5,000-5,000-5,000

Operating costs (excl. deprec.)-25,000-25,000-25,000

Basis x rate = deprec.Rate = 33.33% -26,667 -26,667 -26,667


TaxesRate = 35% -3,792 -3,792 -3,792

EBIT(1 T)$ 7,042$ 7,042$ 7,042

+ Depreciation 26,667 26,667 26,667

Project CFs-$80,000$33,708$33,708$33,708

NPV$3,828

.(13-2) Project NPVC I KAnswer: d MEDIUM/HARD

t = 0t = 1t = 2t = 3

InvestmentWACC = 10%-$ 65,000

Opportunity cost-100,000

Revenues$123,000$123,000$123,000


Basis x rate = deprec. Rate = 33.33% -21,667 -21,667 -21,667

Operating income (EBIT)$ 76,333$76,333$76,333

TaxesRate = 35% 26,717 26,717 26,717

EBIT(1 T)$49,617$49,617$49,617

+ Depreciation 21,667 21,667 21,667

Project CFs-$165,000$ 71,283$ 71,283$ 71,283

NPV$12,271

.(13-7) Replacement chain approachC IAnswer: a MEDIUM/HARD

WACC = 9.25%

Project S:01234

CFs-$10,000$6,000$ 8,000

Extended CFs -10,000$6,000$8,000

Total CFs-$10,000$6,000-$ 2,000$6,000$8,000

NPVS = $4,033.40

Project L:01234

CFs-$10,000$4,373$4,373$4,373$4,373

NPVL = $4,089.90

NPVL NPVS = $56.50

.(13-2) NPV including inflationC I KAnswer: c HARD

Base Case Calculations

t = 0t = 1t = 2t = 3

Investment costWACC = 10%-$200,000

Inflation5.0%5.0%5.0%

Price per unit$25.00$26.25$27.56

VC per unit$20.20$21.21$22.27

Units sold50,00050,00050,000

Sales revenues$1,250,000$1,312,500$1,378,125

Fixed op. cost (excl. deprec.)150,000150,000150,000

Variable op costs1,010,0001,060,5001,113,525

DepreciationRate = 33.333% 66,667 66,667 66,667

Operating income (EBIT)$ 23,333$ 35,333$ 47,933

TaxesRate = 40% 9,333 14,133 19,173

EBIT(1 T)$ 14,000$ 21,200$ 28,760

+ Depreciation 66,667 66,667 66,667

Project CFs-$200,000$ 80,667$ 87,867$ 95,427

NPV$17,646

.(13-2) NPV including inflationC I KAnswer: c HARD

NPV with no adjustment

t = 0t = 1t = 2t = 3


Inflation (set to 0%)0.0%0.0%0.0%

Price per unit$25.00$25.00$25.00

VC per unit$20.20$20.20$20.20

Units sold49,00049,00049,000

Sales revenues$1,225,000$1,225,000$1,225,000


Variable op costsper unit = $20.20989,800989,800989,800



TaxesRate = 40% 7,413 7,413 7,413

EBIT(1 T)$ 11,120$ 11,120$ 11,120

+ Depreciation 66,667 66,667 66,667

Project CFs-$200,000$ 77,787$ 77,787$ 77,787

NPV w/o infl. adjustment-$6,556

NPV with adjustment

t = 0t = 1t = 2t = 3


Inflation4.0%4.0%4.0%

Price per unit$25.00$26.00$27.04

VC per unit$20.20$21.01$21.85

Units sold49,00049,00049,000

Sales revenues$1,225,000$1,274,000$1,324,960


Variable op costsper unit = $20.20989,8001,029,3921,070,568



TaxesRate = 40% 7,414 11,177 15,091

EBIT(1 T)$ 11,120$ 16,765$ 22,636

+ Depreciation 66,666 66,666 66,666

Project CFs-$200,000$ 77,786$ 83,431$ 89,302

NPV w/infl. adjustment$6,760

Increase w/infl. adjustment$13,316

.(13-2) Project NPVC I KAnswer: a HARD

t = 0t = 1t = 2t = 3

Investment in fixed assetsWACC = 10%-$75,000

Investment in NOWC-$15,000

Sales revenues$75,000$75,000$75,000

- Operating costs (excl. deprec.)25,00025,00025,000



- TaxesRate = 35% 8,750 8,750 8,750

EBIT(1 T)$16,250$16,250$16,250

+ Depreciation 25,000 25,000 25,000

EBIT(1 T) + DEP-$90,000$41,250$41,250$41,250

Recovery of NOWC 15,000

Project CFs-$90,000$41,250$41,250$56,250

NPV$23,852

.(13-2) Project NPVC I KAnswer: c HARD

t = 0t = 1t = 2t = 3

Investment in fixed assetsWACC = 10%-$70,000

Investment in NOWC-10,000

Sales revenues$75,000$75,000$75,000


Depreciation Rate = 33.333% -23,333 -23,333 -23,333


TaxesRate = 35% 7,583 7,583 7,583

EBIT(1 T)$14,083$14,083$14,083

+ Depreciation 23,333 23,333 23,333

EBIT(1 T) + DEP-$80,000$37,417$37,417$37,417

Recovery of NOWC10,000

Salvage value, pre-tax5,000

Tax on salvage valueRate = 35% 1,750

Project CFs-$80,000$37,417$37,417$50,667

NPV$23,005

.(13-5) Sensitivity analysisC I KAnswer: e HARD

Base Case Calculations

t = 0t = 1t = 2t = 3

Investment costWACC: 10%-$60,000

Cars washed2,8002,8002,8002,800

Price per car$25.00$25.00$25.00$25.00

Variable cost/unit$5.375$5.375$5.375$5.375

Sales revenues$70,000$70,000$70,000

Fixed op. cost (excl. deprec.) $10,00010,00010,00010,000

Variable op costs$5.37515,05015,05015,050



TaxesRate = 35% 8,733 8,733 8,733

EBIT(1 T)$16,218$16,218$16,218

+ Depreciation 20,000 20,000 20,000

Project CFs-$60,000$36,218$36,218$36,218

Base-Case NPV$30,068

Bad Case Calculations

t = 0t = 1t = 2t = 3

Investment cost-$60,000

Cars washedDeclines by: 40%1,6801,6801,680

Price per car$25$25$25

Variable cost/unit$5.375$5.375$5.375

Sales revenues$42,000$42,000$42,000


Variable op costs9,0309,0309,030

Depreciation 20,000 20,000 20,000


Taxes 1,040 1,040 1,040

EBIT(1 T)$1,931$1,931$1,931

+ Depreciation 20,000 20,000 20,000

Project CFs-$60,000$21,931$21,931$21,931

Bad-Case NPV-$5,462

Change in NPV-$35,530

.(13A) NPV and depreciationC IAnswer: a EASY/MEDIUM

.(13A) Depreciation cash flowsC IAnswer: c MEDIUM

Page 440True/FalseChapter 13: Cash Flow and Risk

2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Chapter 13: Cash Flow and RiskTrue/FalsePage 441 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CASH FLOW ESTIMATION AND RISK ANALYSIS EXERCISE

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