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Exam 11: Cash Flow Estimation and Risk Analysis

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Question 31

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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?

A) 1.20
B) 1.26
C) 1.32
D) 1.39
E) 1.46

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

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Question 32

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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

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Question 33

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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.

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? $\begin{array}{lc}\text { Equipment cost (depreciable basis) } & \$ 65,000 \\\text { Straight-line depreciation rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 60,000 \\\text { Operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 35,0 \%\end{array}$

Garden-Grow Products 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 some additional 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 are constant in Years 1 to 3.) $\begin{array}{lr}\text { WACC } & 10.0 \% \\\text { Net investment in fixed assets (basis) } & \$ 75,000 \\\text { Required new working capital } & \$ 15,000 \\\text { Straight-line deprec. rate } & 33.333 \% \\\text { Sales revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec.) , each year } & \$ 25,000\\\text { Tax rate } & 35.0 \%\end{array}$

Which of the following statements is CORRECT?

VR Corporation has the opportunity to invest in a new project,the details of which are shown below.What is the Year 1 cash flow for the project? $\begin{array}{lr}\text { Sales revenues, each year } & \$ 42,500 \\\text { Depreciation } & \$ 10,000 \\\text { Other operating costs } & \$ 17,000 \\\text { Interest expense } & \$ 4,000 \\\text { Tax rate } & 35,0 \%\end{array}$

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.

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?

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? Equipment cost (depreciable basis) $\$ 70,000$ Sales revenues, each year $\$ 42,500$ Operating costs (excl. deprec.) $\$ 25,000$ Tax rate $35.0 \%$

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

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

Which of the following statements is CORRECT?

Sylvester Media 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.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 adjustment is required.What is the difference in the expected NPV if the inflation adjustment is made vs.if it is not made? $\begin{array}{lr}\text { WACC } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 200,000 \\\text { Units sold } & 50,000 \\\text { Average price per unit, Year 1 } & \$ 25.00 \\\text { Fixed op. cost excl. deprec. (constant) } & \$ 150,000 \\\text { Variable op. cost/unit, Year 1 } & \$ 20.20 \\\text { Annual depreciation rate } & 33.333 \% \\\text { Expected inflation } & 4.00 \% \\\text { Tax rate } & 35.0 \%\end{array}$

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.

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.

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.

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?

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

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.