Using Discounted Cash-Flow Analysis to Make Investment Decisions

True / False Questions

1. Capital budgeting analysis focuses on cash flow as opposed to profits.
2. Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows (i.e., the difference between cash flow with project and cash flow without project).
3. Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows.
4. Opportunity costs are evaluated for investment decisions at their historical (that is, book) cost.
5. The method of financing a project affects the determination of its cash flows for capital budgeting purposes.
6. In project analysis, allocations of overhead should be limited to only those that represent additional expense.
7. If a project permits a reduction in the level of working capital, this reduction is assumed to increase cash flows.

8. An asset in the MACRS 5-year class life will have depreciation expense in six different years.

9. The present value of the total depreciation tax shield will be higher when an asset uses MACRS than when depreciated straight-line.
10. Upon the sale of equipment at the end of its useful life, tax liability will be incurred whenever the book value of the equipment exceeds the sales price.
11. When additional funds must be committed to working capital, those funds are assumed to be recovered at the end of the project’s life.
12. Discounting real cash flows with real interest rates gives an overly optimistic idea of a project’s value.
13. Sunk costs remain the same whether or not you accept the project.
14. Sunk costs do not affect project NPV.
15. Investments in working capital, just like investments in plant and equipment, result in cash inflows.
16. A project will always generate extra overhead costs.
17. Discounting real cash flows at a nominal rate is a serious mistake.
18. Suppose you finance a project partly with debt, you should neither subtract the debt proceeds from the required investment, nor would you recognize the interest and principal payments on the debt as cash outflows.
19. When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them.
20. As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected.
21. The total depreciation tax shield equals the product of depreciation and the tax rate.
22. Cash flow from operations = (revenues – cash expenses) x (1 – tax rate) + (depreciation x tax rate).

Multiple Choice Questions

23. Corporate income statements are designed primarily to show:
    A.cash flows during a period.
    B. account balances at the end of a period.
    C. performance during a period.
    D. market values of assets and liabilities.
24. Projects that are calculated as having negative NPVs should be:
    A.depreciated over a longer time period.
    B. charged less in overhead costs.
    C. discounted using lower rates.
    D. rejected or abandoned.
25. If the adoption of a new product will reduce the sales of an existing product, then the:
    A. new product should not be undertaken.
    B. old product should be abandoned.
    C. incremental benefits of the new product may be over-estimated.
    D. incremental benefits of the new product may be under-estimated.
26. The value of a proposed capital budgeting project depends upon the:
    A.total cash flows produced.
    B. incremental cash flows produced.
    C. accounting profits produced.
    D. increase in total sales produced.
27. The rationale for not including sunk costs in capital budgeting decisions is that they:
    A.are usually small in magnitude.
    B. revert at the end of the investment.
    C. have no incremental effect.
    D. reduce the estimated NPV.
28. If a project’s cash flows exceed the project’s incremental cash flows, it is likely that the:
    A.project interacts with other aspects of the firm.
    B. project must have high depreciation expense.
    C. opportunity cost of capital must be high.
    D. project will have a negative NPV.
29. When is it appropriate to include sunk costs in the evaluation of a project?
    A.Include sunk costs when they are relatively large.
    B. Include sunk costs if it improves the project’s NPV.
    C. Include sunk costs if they are considered to be overhead costs.
    D. It is never appropriate to include sunk costs.
30. A cost should be considered sunk when it:
    A.is fully depreciated.
    B. produces no additional sales revenues.
    C. has no effect on future flows.
    D. is replaced by costs that are not yet sunk.
31. The opportunity cost of an asset:
    A. should be depreciated annually.
    B. can differ depending on market conditions.
    C. is typically ignored in capital budgeting.
    D. is important only for parcels of land.