Finance Find Out With This Quiz!

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  • 1/25 Questions

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

    • True
    • False
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About This Quiz

Explore the complexities of capital budgeting in this engaging quiz! Test your understanding of project cash flow estimation, the relevance of noncash items, and the impact of opportunity costs. Perfect for finance professionals and students aiming to sharpen their analytical skills.

Finance Find Out With This Quiz! - Quiz

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  • 2. 

    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.  

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Estimating project cash flows is indeed the most important step in the capital budgeting process because it determines the potential profitability and viability of a project. Without accurate cash flow estimates, it would be difficult to make informed decisions about whether to invest in a project. While methodology, such as NPV versus IRR, is important in evaluating projects, it is secondary to the accuracy of cash flow estimates. Therefore, the statement that estimating project cash flows is generally the most important and difficult step in the capital budgeting process is true.

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  • 3. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The statement suggests that while it may be difficult to accurately predict the revenue generated by a project, the initial outlays and subsequent costs can be forecasted accurately. However, the correct answer is false, indicating that the statement is not true. This implies that even the initial outlays and subsequent costs of large product development projects cannot be forecasted with great accuracy.

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  • 4. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The explanation for the given correct answer is that changes in noncash balance sheet accounts such as inventory are indeed included in a capital budgeting analysis. This is because capital budgeting focuses on cash flows, which include both cash inflows and outflows. Changes in inventory can affect cash flows, as they represent changes in the amount of cash tied up in inventory. Therefore, these changes need to be considered in a capital budgeting analysis.

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  • 5. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    If an investment project would make use of land that the firm already owns, it is important to consider the opportunity cost of that land. This means that the project should be charged with the value that could have been obtained if the land had been used for an alternative purpose, such as selling or renting it out. By including the opportunity cost, the firm can accurately assess the profitability and viability of the investment project. Therefore, the statement "True" is correct.

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  • 6. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    When debt is used to finance a project, interest payments should not be included in the analysis of cash flows. This is because interest payments are considered a financing cost and not an operating cost. Including interest payments in the analysis would artificially inflate the expenses and potentially lead to incorrect financial projections. Therefore, the statement is false.

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  • 7. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    The explanation for the given correct answer is that when conducting a capital budgeting analysis, it is important to consider only the cash flows that are directly related to the decision to undertake the project. These cash flows, also known as incremental cash flows, are the additional cash flows that will be generated as a result of the project. By including only these incremental cash flows in the analysis, it ensures that the analysis is focused on the relevant financial impact of the project and provides a more accurate assessment of its potential profitability.

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  • 8. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The statement is false because externalities, which are costs and benefits that do not flow directly to or from the firm, should still be considered as part of the capital budgeting analysis. These externalities can have indirect impacts on the company's financial performance and should not be ignored when evaluating the feasibility of a project.

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  • 9. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    In cash flow estimation, it is important to consider externalities that may impact the firm's long-run cash flows. Externalities refer to the effects of a firm's actions on third parties or the environment. These external factors can have significant consequences on the firm's financial performance and cash flow generation. Therefore, it is crucial to take into account these externalities when estimating cash flows to ensure a more accurate assessment of the firm's financial health and future prospects.

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  • 10. 

    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.  

    • True

    • False

    Correct Answer
    A. False
    Explanation
    If the CFO believes that an externality is present in a project but cannot be accurately quantified, it does not mean that the externality should be ignored. Even if the estimates of its effect are just guesses, it is still important to consider the potential impact it may have on the project. Ignoring the externality could lead to an incomplete analysis and potentially overlook significant factors that could affect the project's outcomes. Therefore, the correct answer is False.

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  • 11. 

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

    • True

    • False

    Correct Answer
    A. False
    Explanation
    Changes in net working capital should be reflected in a capital budgeting cash flow analysis because working capital is an important component of a company's overall cash flow. Working capital includes current assets and liabilities, such as inventory, accounts receivable, and accounts payable. These items directly impact a company's ability to generate cash and should be considered in capital budgeting decisions. Therefore, the statement that changes in net working capital should not be reflected in a capital budgeting cash flow analysis is false.

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  • 12. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The explanation for the given answer, which is False, is that the statement is incorrect. The primary advantage of using accelerated depreciation is not that the total amount of depreciation that can be taken is greater, but rather that it allows for larger deductions in the early years of an asset's life, which can provide significant tax savings. Straight-line depreciation, on the other hand, evenly spreads out the depreciation expense over the asset's useful life.

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  • 13. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Accelerated depreciation allows for larger deductions in the earlier years of an asset's life, resulting in higher tax savings. This is because the depreciation expense is higher in the early years and decreases over time. By contrast, straight-line depreciation allocates the same amount of depreciation expense each year. Therefore, the present value of the tax savings provided by accelerated depreciation will be higher compared to straight-line depreciation, assuming all other factors remain constant.

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  • 14. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    Using accelerated depreciation instead of straight-line depreciation does not necessarily result in a higher NPV for a project. The choice of depreciation method does not directly impact the total cash flows of a project. NPV is determined by discounting the project's cash flows, and the choice of depreciation method does not affect the timing or amount of these cash flows. Therefore, the statement is false.

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  • 15. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    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. This is because accelerated depreciation allows for higher depreciation expenses in the earlier years of the project, which in turn reduces taxable income and increases cash flows. This leads to higher NPV and IRR for the project, making it more likely to be accepted.

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  • 16. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Accelerated depreciation allows profitable firms to shift cash flows forward, which increases their present value. However, it also lowers the reported profits for the current year due to higher depreciation expenses. Despite this, the reported profits issue can be resolved by using different depreciation methods for tax and stockholder reporting purposes. Therefore, the statement is true.

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  • 17. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    When a firm's projects differ in risk, it is important to consider the risk associated with each project when evaluating its potential profitability. By using a risk-adjusted discount rate, the firm can account for the varying levels of risk and ensure that the project's expected cash flows are appropriately discounted. This allows for a more accurate assessment of the project's value and helps the firm make better investment decisions. Therefore, it is true that one way of handling the problem of differing project risks is to evaluate each project with the appropriate risk-adjusted discount rate.

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  • 18. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The statement suggests that using superior analytical techniques, such as NPV, 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. However, the correct answer is False. This implies that even with these techniques, the problem of poor cash flow estimation cannot be completely overcome and may still lead to incorrect accept/reject decisions.

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  • 19. 

    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.  

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Large, complex projects that take several years to develop are often associated with uncertainties and risks that make it challenging to accurately estimate their revenues and costs. Due to the long time frame and the potential for unforeseen events, traditional financial analysis methods may not provide reliable results. Therefore, subjective judgment is often employed to supplement discounted cash flow analysis in order to account for these uncertainties and make more informed decisions. This statement suggests that it is true that subjective judgment is often used for such projects.

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  • 20. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    Financial analysts should follow two cardinal rules to avoid capital budgeting errors. The first rule is that the numerator in the NPV equation should use income calculated in accordance with generally accepted accounting principles. The second rule states that all incremental cash flows should be considered when making accept/reject decisions. Therefore, the statement that the answer is false is incorrect, as both rules are true and should be followed by financial analysts.

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  • 21. 

    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.

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Opportunity costs refer to the potential benefits or profits that could be obtained from an alternative option that is not chosen. In this case, the statement suggests that opportunity costs include the cash inflows that could be generated from the assets the firm already owns if those assets are not used for the project being evaluated. This means that if the firm decides to use its assets for the project, it would be forgoing the potential cash inflows that could have been generated from those assets. Therefore, the statement is true.

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  • 22. 

    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.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The explanation for the given correct answer is that the statement is true. Sunk costs are costs that have already been incurred and cannot be recovered. In this scenario, the lost sales on the older book are a sunk cost because they have already occurred and cannot be changed. When considering whether to bring out a new finance text, the analysis should only focus on the projected revenues and costs associated with the new book, rather than considering the lost sales on the older book. Therefore, the statement "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" is true.

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  • 23. 

    . The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required.  This situation is especially true for replacement projects.

    • True

    • False

    Correct Answer
    A. False
    Explanation
    The explanation for the given correct answer is that the statement is incorrect. The change in net working capital associated with new projects is not always positive. It depends on the specific circumstances of the project. While it is true that new projects may require additional working capital, it is also possible for projects to generate cash inflows that offset the need for additional working capital. Therefore, the statement that the change in net working capital associated with new projects is always positive is false.

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  • 24. 

    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. .

    • True

    • False

    Correct Answer
    A. False
    Explanation
    Accelerated depreciation causes net income reported to stockholders to be lower and cash flows higher in the early years of a project's life, but higher net income and lower cash flows in the later years. This is because accelerated depreciation expenses more of the asset's cost in the early years, reducing net income, but also reducing taxable income and therefore taxes paid, resulting in higher cash flows. In the later years, the depreciation expense is lower, leading to higher net income and lower cash flows. Therefore, the statement is false.

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  • 25. 

    . 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.  

    • True

    • False

    Correct Answer
    A. True
    Explanation
    Sensitivity analysis is a tool used to measure the stand-alone risk of a project by examining how changes in input variables affect the project's NPV or IRR. In this case, the explanation states that the steeper the graph of the relationship line between the size of the independent variable and the NPV, the more risky the project is. This is because a small change in the independent variable has a larger impact on the NPV, indicating higher risk. Therefore, the statement is true.

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  • Current Version
  • Mar 21, 2023
    Quiz Edited by
    ProProfs Editorial Team
  • Jan 22, 2012
    Quiz Created by
    Crokakis

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