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Spot-Free 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 new 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 decline? (Hint: Note that cash flows are constant at the Year 1 level,whatever that level is.)  WACC 10.0% Net investment cost (depreciable basis)  $60,000 Number of cars washed 2,800 Average price per car $25.00 Fixed op. cost (excl. deprec.)  $10,000 Variable op. costunit (i.e., VC per car washed)  $5.375 Annual depreciation $20,000 Tax rate 35.0%\begin{array} { l r } \text { WACC } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 60,000 \\\text { Number of cars washed } & 2,800 \\\text { Average price per car } & \$ 25.00 \\\text { Fixed op. cost (excl. deprec.) } & \$ 10,000 \\\text { Variable op. costunit (i.e., VC per car washed) } & \$ 5.375 \\\text { Annual depreciation } & \$ 20,000 \\\text { Tax rate } & 35.0 \%\end{array}


A) $28,939
B) $30,462
C) $32,066
D) $33,753
E) $35,530

F) B) and C)
G) A) and E)

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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.)  WACC 10.0% Net investment in fixed assets (basis)  $75,000 Required new working capital $15,000 Straight-line deprec. rate 33.333% Sales revenues, each year $75,000 Operating costs (excl. deprec.) , each year $25,000 Tax rate 35.0%\begin{array} { l r } \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}


A) $23,852
B) $25,045
C) $26,297
D) $27,612
E) $28,993

F) B) and E)
G) A) and E)

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


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

F) None of the above
G) A) and E)

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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

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The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e.,the initial investment cost,the annual operating cash flows,and the terminal cash flow) ,then discounting those cash flows at the company's 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 investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's 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 project's own direct cash flows.

F) A) and B)
G) A) and C)

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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

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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

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A firm is considering a new project whose risk is greater than the risk of the firm's 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 NPV of the project to reflect its greater risk.
B) Reject the project, since its acceptance would increase the firm's risk.
C) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
D) Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
E) Increase the estimated IRR of the project to reflect its greater risk.

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

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Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?


A) Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all.
B) Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated.
C) Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure.
D) DCF techniques were originally developed to value passive investments (stocks and bonds) . However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.
E) The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

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

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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

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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

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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

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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

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Laramie Labs uses a risk-adjustment when evaluating projects of different risk.Its overall (composite) WACC is 10%,which reflects the cost of capital for its average asset.Its assets vary widely in risk,and Laramie evaluates low-risk projects with a WACC of 8%,average-risk projects at 10%,and high-risk projects at 12%.The company is considering the following projects:  Project ‾ Risk ‾ Expected Return ‾ A  High 15% B  Average 12% C  High 11% D  Low 9% E  Low 6%\begin{array} { c c c } \underline{\text { Project }} &\underline{ \text { Risk }} &\underline{ \text { Expected Return }} \\\text { A } & \text { High } & 15 \% \\\text { B } & \text { Average } & 12 \% \\\text { C } & \text { High } & 11 \% \\\text { D } & \text { Low } & 9 \% \\\text { E } & \text { Low } & 6 \%\end{array} Which set of projects would maximize shareholder wealth?


A) A and B.
B) A, B, and C.
C) A, B, and D.
D) A, B, C, and D.
E) A, B, C, D, and E.

F) C) and E)
G) A) and E)

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Which of the following statements is CORRECT?


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 project's cash flows will lead to a downward bias in the NPV.
B) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
C) 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.
D) 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.
E) 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.

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

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Which of the following statements is CORRECT?


A) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
B) 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 bank's other offices.
C) 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.
D) If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.
E) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

F) B) and E)
G) All of the above

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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?  WACC 10.0% Net investment cost (depreciable basis)  $200,000 Units sold 50,000 Average price per unit, Year 1 $25.00 Fixed op. cost excl. deprec. (constant)  $150,000 Variable op. cost/unit, Year 1 $20.20 Annual depreciation rate 33.333% Expected inflation 4.00% Tax rate 35.0%\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 } & 4.00 \% \\\text { Tax rate } & 35.0 \%\end{array}


A) $13,286
B) $13,985
C) $14,721
D) $15,457
E) $16,230

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

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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

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Which of the following statements is CORRECT?


A) 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.
B) Well-diversified stockholders do not need to consider market risk when determining required rates of return.
C) Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
D) Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
E) Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

F) D) and E)
G) B) and D)

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Which of the following statements is CORRECT?


A) An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.
B) 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.
C) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

F) A) and E)
G) B) and E)

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