Cash Flow Estimation

1
. A company is considering a new project. The company’s CFO plans to calculate the project’s NPV by discounting the
relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash
flows) at the company’s cost of capital (WACC). Which of the following factors should the CFO include when
estimating the relevant cash flows?
a. Any sunk costs associated with the project.
b. Any interest expenses associated with the project.
c. Any opportunity costs associated with the project.
d. Statements b and c are correct.

2
. When evaluating potential projects, which of the following factors should be incorporated as part of a project’s
estimated cash flows?
a. Any sunk costs that were incurred in the past prior to considering the proposed project.
b. Any opportunity costs that are incurred if the project is undertaken.
c. Any externalities (both positive and negative) that are incurred if the project is undertaken.
d. Statements b and c are correct.

3
. Which of the following is not a cash flow that results from the decision to accept a project?
a. Changes in net operating working capital.
b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.

4
. When evaluating a new project, the firm should consider all of the following factors except:
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project, if the
expenditures have been expensed for tax purposes.
c. Current rental income of a building owned by the firm if it is not used for this project.
d. The decline in sales of an existing product directly attributable to this project.

5
. Which of the following items should Bev’s Beverage Inc. take into account when evaluating a proposed prune juice
project?
a. The company spent P300,000 two years ago to renovate its Cincinnati plant. These renovations were made in
anticipation of another project that the company ultimately did not undertake.
b. If the company did not proceed with the prune juice project, the Cincinnati plant could generate leasing income
of P75,000 a year.
c. If the company proceeds with the prune juice project, it is estimated that sales of the company’s apple juice will
fall by 3 percent a year.
d. Statements b and c are correct.

6
. Twin Hills Inc. is considering a proposed project. Given available information, it is currently estimated that the
proposed project is risky but has a positive net present value. Which of the following factors would make the
company less likely to adopt the current project?
a. It is revealed that if the company proceeds with the proposed project, the company will lose two other
accounts, both of which have positive NPVs.
b. It is revealed that the company has an option to back out of the project 2 years from now, if it is discovered
to be unprofitable.
c. It is revealed that if the company proceeds with the project, it will have an option to repeat the project 4
years from now.
d. Statements a and b are correct.
7
. A company is considering a proposed expansion to its facilities. Which of the following statements is most correct?
a. In calculating the project's operating cash flows, the firm should not subtract out financing costs such as
interest expense, since these costs are already included in the WACC, which is used to discount the project’s
net cash flows.
b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation rate when
calculating the operating cash flows.
c. When estimating the project’s operating cash flows, it is important to include any opportunity costs and sunk
costs, but the firm should ignore cash flows from externalities since they are accounted for elsewhere.
d. Statements a and c are correct.

8
. Lieber Technologies is considering two potential projects, X and Y. In assessing the projects’ risk, the company has
estimated the beta of each project and has also conducted a simulation analysis. Their efforts have produced the
following numbers:
Project X Project Y
Expected NPV P350,000 P350,000
Standard deviation (NPV) P100,000 P150,000
Estimated project beta 1.4 0.8
Estimated correlation of Cash flows are not Cash flows are highly
project’s cash flows with highly correlated with correlated with the
the cash flows of the the cash flows of the cash flows of the
company’s existing projects. existing projects. existing projects.

Which of the following statements is most correct?

a. Project X has a higher level of stand-alone risk relative to Project Y.
b. Project X has a higher level of corporate risk relative to Project Y.
c. Project X has a higher level of market risk relative to Project Y.
d. Statements b and c are correct.

9
. Currently, Purcell Products Inc. has a beta of 1.0, and the sales of all of its products tend to be positively correlated with the
overall economy and the overall market. The company estimates that a proposed new project has a higher standard
deviation than the typical project undertaken by the firm. The company also estimates that the new project’s sales will
do better when the overall economy is down and do poorly when the overall economy is strong. On the basis of this
information, which of the following statements is most correct?
a. The proposed new project has more stand-alone risk than the firm’s typical project.
b. If undertaken, the proposed new project will increase the firm’s corporate risk.
c. If undertaken, the proposed new project will increase the firm’s market risk.
d. Statements a and b are correct.

10
. Risk in a revenue-producing project can best be adjusted for by
a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
d. Picking a risk factor equal to the average discount rate.

11
. A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk project has a WACC
of 8 percent, and an above-average risk project has a WACC of 12 percent. Which of the following independent
projects should the company accept?

a. Project A has average risk and an IRR = 9 percent.

b. Project B has below-average risk and an IRR = 8.5 percent.
c. Project C has above-average risk and an IRR = 11 percent.
d. All of the projects above should be accepted.
12
. Downingtown Industries has an overall (composite) WACC of 10 percent. This cost of capital reflects the cost of capital for a
Downingtown project with average risk; however, there are large risk differences among its projects. The company
estimates that low-risk projects have a cost of capital of 8 percent and high-risk projects have a cost of capital of 12
percent. The company is considering the following projects:

Project Expected Return Risk

A 15% High
B 12 Average
C 11 High
D 9 Low
E 6 Low

Which of the projects should the company select to maximize shareholder wealth?

a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.

13
. Adams Audio is considering whether to make an investment in a new type of technology. Which of the following
factors should the company consider when it decides whether to undertake the investment?

a. The company has already spent P3 million researching the technology.

b. The new technology will affect the cash flows produced by its other operations.
c. If the investment is not made, then the company will be able to sell one of its laboratories for P2 million.
d. Statements b and c should be considered.

14
. Pickles Corp. is a company that sells bottled iced tea. The company is thinking about expanding its operations into the
bottled lemonade business. Which of the following factors should the company incorporate into its capital
budgeting decision as it decides whether or not to enter the lemonade business?
a. If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent as some
consumers switch from iced tea to lemonade.
b. Two years ago the company spent P3 million to renovate a building for a proposed project that was never
undertaken. If the project is adopted, the plan is to have the lemonade produced in this building.
c. If the company doesn’t produce lemonade, it can lease the building to another company and receive after-tax
cash flows of P500,000 a year.
d. Statements a and c are correct.

15
. Which of the following is not considered a relevant concern in deter- mining incremental cash flows for a new product?
a. The use of factory floor space that is currently unused but available for production of any product.
b. Revenues from the existing product that would be lost as a result of some customers switching to the new
product.
c. Shipping and installation costs associated with preparing the machine to be used to produce the new product.
d. The cost of a product analysis completed in the previous tax year and specific to the new product.

16
. Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital
budgeting analysis?
a. The return on invested capital is the only relevant cash flow.
b. Only incremental cash flows are relevant to the accept/reject decision.
c. Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
d. Statements a and b are correct.

17
. Which of the following statements is correct?
 a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as
reflected in their probability distributions.
b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less
risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in
the project’s NPV.
c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a
relatively powerful computer, coupled with an efficient financial planning software package, whereas
simulation analysis can be done using a PC with a spreadsheet program or even a calculator.
d. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key
variables and the likely range of variable values.

18
. Rojas Computing is developing a new software system for one of its clients. The system has an up-front cost of P75
million (at t = 0). The client has forecasted its inventory levels for the next five years as shown below:

Year Inventory
1 P1.0 billion
2 1.2 billion
3 1.6 billion
4 2.0 billion
5 2.2 billion

Rojas forecasts that its new software will enable its client to reduce inventory to the following levels:

Year Inventory
1 P0.8 billion
2 1.0 billion
3 1.4 billion
4 1.7 billion
5 1.9 billion

After Year 5, the software will become obsolete, so it will have no further impact on the client’s inventory levels.
Rojas’ client is evaluating this software project as it would any other capital budgeting project. The client estimates
that the weighted average cost of capital for the software system is 10 percent. What is the estimated NPV (in
millions of pesos) of the new software system?
a. P233.56
b. P489.98
c. P625.12
d. P813.55
19
. Ellison Products is considering a new project that develops a new laundry detergent, WOW. The company has estimated
that the project’s NPV is P3 million, but this does not consider that the new laundry detergent will reduce the
revenues received on its existing laundry detergent products. Specifically, the company estimates that if it develops
WOW the company will lose P500,000 in after-tax cash flows during each of the next 10 years because of the
cannibalization of its existing products. Ellison’s WACC is 10 percent. What is the net present value (NPV) of
undertaking WOW after considering externalities?
a. P2,927,716.00
b. P3,000,000.00
c. -P 72,283.55
d. P2,807,228.00

20
. For a new project, Armstead Inc. had planned on depreciating new machinery that costs P300 million on a 4-year,
straight-line basis. Suppose now, that Armstead decides to depreciate the new machinery on an accelerated
basis according to the following depreciation schedule:
 MACRS
Depreciation
Year Rates
1 20%
2 32
3 19
4 12
5 11
6 6

The project for which the machinery has been purchased ends in four years, and as a result the machinery is going to
be sold at its salvage value of P50,000,000. Under this accelerated depreciation method, what is the after-tax cash
flow expected to be generated by the sale of the equipment in Year 4? Assume the firm’s tax rate is 40 percent.
a. P31,800,000
b. P41,600,000
c. P50,400,000
d. P51,600,000

21
. Mars Inc. is considering the purchase of a new machine that will reduce manufacturing costs by P5,000 annually. Mars
will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end
of its 5-year operating life for P10,000. The firm expects to be able to reduce net operating working capital by
P15,000 when the machine is installed, but required net operating working capital will return to its original level
when the machine is sold after 5 years. Mars’ marginal tax rate is 40 percent, and it uses a 12 percent cost of
capital to evaluate projects of this nature. The applicable depreciation rates are 20 percent, 32 percent, 19
percent, 12 percent, 11 percent, and 6 percent. If the machine costs P60,000, what is the project’s NPV?
a. -P15,394
b. -P14,093
c. -P58,512
d. -P21,493

22
. Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal, the company’s CFO is
considering the following facts:

 The new business will require the company to purchase additional fixed assets that will cost P600,000 at t
= 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over three
years. (Annual depreciation will be P200,000 per year at
t = 1, 2, and 3.)
 At the end of three years, the company will get out of the business and will sell the fixed assets at a
salvage value of P100,000.
 The project will require a P50,000 increase in net operating working capital at t = 0, which will be
recovered at t = 3.
 The company’s marginal tax rate is 35 percent.
 The new business is expected to generate P2 million in sales each year (at t = 1, 2, and 3). The
operating costs excluding deprecia-tion are expected to be P1.4 million per year.
 The project’s cost of capital is 12 percent.

What is the project’s net present value (NPV)?

a. P536,697
b. P 86,885
c. P 81,243
d. P 56,331

23
. Rio Grande Bookstores is considering a major expansion of its business. The details of the proposed expansion project
are summarized below:
 The company will have to purchase P500,000 in equipment at t = 0. This is the depreciable cost.
  The project has an economic life of four years.
 The cost can be depreciated on a MACRS 3-year basis, which implies the following depreciation schedule:

MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07

 At t = 0, the project requires that inventories increase by P50,000 and accounts payable increase by
P10,000. The change in net operating working capital is expected to be fully recovered at t = 4.
 The project’s salvage value at the end of four years is expected to be P0.
 The company forecasts that the project will generate P800,000 in sales the first two years (t = 1 and 2)
and P500,000 in sales during the last two years (t = 3 and 4).
 Each year the project’s operating costs excluding depreciation are expected to be 60 percent of sales
revenue.
 The company’s tax rate is 40 percent.
 The project’s cost of capital is 10 percent.
What is the net present value (NPV) of the proposed project?
a. P159,145
b. P134,288
c. P162,817
d. P150,776

24
. Your company is considering a machine that will cost P1,000 at Time 0 and can be sold after 3 years for P100. To operate
the machine, P200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is
retired at the end of Year 3. The machine will produce sales revenues of P900 per year for 3 years and variable
operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from
today (at Time 1). The machine will have depreciation expenses of P500, P300, and P200 in Years 1, 2, and 3,
respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a
tax refund from this project if the project’s income is negative, and a 10 percent cost of capital. Inflation is zero.
What is the project’s NPV?
a. P 6.24
b. P 7.89
c. P 8.87
d. P 9.15

25
. Your company is considering a machine that will cost P50,000 at Time 0 and that can be sold after 3 years for P10,000.
P12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation
is closed at the end of Year 3. The facility will produce sales revenues of P50,000 per year for 3 years and variable
operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash
inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses
of P40,000, P5,000, and P5,000 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough
taxable income from other assets to enable it to get a tax refund on this project if the project’s income is negative,
and a 15 percent cost of capital. Inflation is zero. What is the project’s NPV?
a. P 7,673.71
b. P12,851.75
c. P17,436.84
d. P24,989.67

26
. Buckeye Books is considering opening a new production facility in Toledo, Ohio. In deciding whether to proceed with the
project, the company has accumulated the following information:
  The estimated up-front cost of constructing the facility at t = 0 is P10 million. For tax purposes the facility
will be depreciated on a straight-line basis over 5 years.
 The company plans to operate the facility for 4 years. It estimates today that the facility’s salvage value at t
= 4 will be P3 million.
 If the facility is opened, Buckeye will have to increase its inventory by P2 million at t = 0. In addition, its
accounts payable will increase by P1 million at t = 0. The company’s net operating working capital will be
recovered at t = 4.
 If the facility is opened, it will increase the company’s sales by P7 million each year for the 4 years that it will
be operated (t = 1, 2, 3, and 4).
 The operating costs (excluding depreciation) are expected to equal P3 million a year.
 The company’s tax rate is 40 percent.
 The project’s cost of capital is 12 percent.

What is the project’s net present value (NPV)?

a. P0.28 million
b. P0.50 million
c. P0.63 million
d. P1.01 million

27
. As one of its major projects for the year, Steinbeck Depot is considering opening up a new store. The company’s CFO has
collected the following information, and is proceeding to evaluate the project.
 The building would have an up-front cost (at t = 0) of P14 million.
For tax purposes, this cost will be depreciated over seven years using straight-line depreciation.
 The store is expected to remain open for five years. At t = 5, the company plans to sell the store for an estimated
pre-tax salvage value of P8 million.
 The project also requires the company to spend P5 million in cash at t = 0 to purchase additional inventory for the
store. After purchasing the inventory, the company’s net operating working capital will remain unchanged until t =
5. At t = 5, the company will be able to fully recover this P5 million.
 The store is expected to generate sales revenues of P15 million per year at the end of each of the next five years.
Operating costs (excluding depreciation) are expected to be P10 million per year.
 The company’s tax rate is 40 percent.

What is the project’s internal rate of return (IRR)?

a. 15.35%
b. 13.94%
c. 10.64%
d. 12.45%

28
. Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent to evaluate average-risk
projects, and it adds or subtracts 2 percentage points to evaluate projects of more or less risk. Currently, two mutually
exclusive projects are under consideration. Both have a cost of P200,000 and will last 4 years. Project A, a riskier-
than-average project, will produce annual end-of-year cash flows of P71,104. Project B, a less-than-average-risk
project, will produce cash flows of P146,411 at the end of Years 3 and 4 only. Virus Stopper should accept

a. B with a NPV of P10,001.

b. Both A and B because both have NPVs greater than zero.
c. B with a NPV of P8,042.
d. A with a NPV of P7,177.

29
. Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer models. Each will
require a net investment of P5,000. The cash flows for each project are shown below:
Year Project A Project B
1 P2,000 P3,000
 2 2,500 2,600
3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model A is an
average-risk project. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of capital when eval-
uating high-risk projects. The cost of capital used for average-risk projects is 12 percent. Which of the following
statements regarding the NPVs for Models A and B is most correct?

a. NPVA = P 380; NPVB = P1,815

b. NPVA = P 197; NPVB = P1,590
c. NPVA = P 380; NPVB = P1,590
d. NPVA = P5,380; NPVB = P6,590

30
. The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive projects. The
discount rate used for Project A is 12 percent. Further, Project A costs P15,000, and it would be depreciated using
MACRS. It is expected to have an after-tax salvage value of P5,000 at the end of 6 years and to produce after-tax
cash flows (including depreciation) of P4,000 for each of the 6 years. Project B costs P14,815 and would also be
depreciated using MACRS. B is expected to have a zero salvage value at the end of its 6-year life and to produce
after-tax cash flows (including depreciation) of P5,100 each year for 6 years. The Unlimited’s marginal tax rate is 40
percent. What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?
a. 15%
b. 16%
c. 18%
d. 20%

Answers
1
C
2
D
3
C
4
B
5
D
6
A
7
A
8
C
9
A
10
B
11
B
12
C
13
D
14
D
15
D
16
B
17
A
18
D
19
C
20
C
21
D
22
A
23
A
24
B
25
A
26
D
27
B
28
A
29
C
30
B