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Exam 13: Cash Flow Estimation and Risk Analysis

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Question 41

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Brandt Enterprises is considering a new project that has a cost of $1,000,000,and the CFO set up the following simple decision tree to show its three most likely scenarios.The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so,but to obtain this abandonment option,it would have to make a payment to those parties.How much is the option to abandon worth to the firm?

A) $55.08
B) $57.98
C) $61.03
D) $64.08
E) $67.29

F) None of the above
G) C) and D)

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Question 42

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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

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Question 43

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Kasper Film Co.is selling off some old equipment it no longer needs because its associated project has come to an end.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 equipment's 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.

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.

Which of the following statements is CORRECT?

Shultz Business Systems 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.This is just one of many projects for the firm,so any losses can be used to offset gains on other firm projects.What is the project's expected NPV? $\begin{array} { l r } \text { WACC } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 200,000 \\\text { Units sold } & 50,000 \\\text { Average price per unit, Year 1 } & \$ 25.00 \\\text { Fixed op. cost excl. deprec. (constant) } & \$ 150,000 \\\text { Variable op. cost/unit, Year 1 } & \$ 20.20 \\\text { Annual depreciation rate } & 33.333 \% \\\text { Expected inflation rate per year } & 5.00 \% \\\text { Tax rate } & 40.0 \%\end{array}$

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.

Weston Clothing Company is considering manufacturing a new style of shirt,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 new 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 Weston's 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.) $\begin{array} { l r } \text { WACC } & 10.0 \% \\\text { Pre-tax cash flow reduction for other products (cannibalization) } & \$ 5,000 \\\text { Investment cost (depreciable basis) } & \$ 80,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year for } 3 \text { years } & \$ 67,500 \\\text { Annual operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$

Which of the following procedures best accounts for the relative risk of a proposed project?

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.

Which of the following statements is CORRECT?

Your new employer,Freeman 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 33.33%,44.45%,14.81%,and 7.41% 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? $\begin{array} { l l } \text { Equipment cost (depreciable basis) } & \$ 65,000 \\\text { Sales revenues, each year } & \$ 60,000 \\\text { Operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Whitestone Products 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 33.33%,44.45%,14.81%,and 7.41% 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? $\begin{array} { l l } \text { Equipment cost (depreciable basis) } & \$ 70,000 \\\text { Sales revenues, each year } & \$ 42,500 \\\text { Operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 35.0 \%\end{array}$

In your first job with TBL Inc.your task is to consider a new project whose data are shown below.What is the project's Year 1 cash flow? $\begin{array}{c}\begin{array}{lll}\text {Sales revenues}\\\text {Depteciation}\\\text {Other operating costs}\\\text {Tax rate}\end{array}\begin{array}{r}\$ 22,000 \\\$ 8,000 \\\$12,000 \\35.0 \%\end{array}\end{array}$

Which of the following statements is CORRECT?

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.