Corporate Finance【Reading 36】Sample project, 2012, following

Gypsy

Which of the following steps is least likely to be an administrative step in the capital budgeting process?

A) Arranging financing for capital projects.

B) Conducting a post-audit to identify errors in the forecasting process.

C) Forecasting cash flows and analyzing project profitability.

---

Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are:

• Idea generation
• Analyzing project proposals
• Creating the firm-wide capital budget
• Monitoring decisions and conducting a post-audit

Gypsy

Which of the following types of capital budgeting projects are most likely to generate little to no revenue?

A) Replacement projects to maintain the business.

B) Regulatory projects.

C) New product or market development.

---

Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.

Gypsy

Financing costs for a capital project are:

A) subtracted from the net present value of a project.

B) captured in the project’s required rate of return.

C) subtracted from estimates of a project’s future cash flows.

---

Financing costs are reflected in a project’s required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

Gypsy

Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting:
Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project.
Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project.
Which of the following regarding Lutz’s statements is most accurate?

Statement 1

Statement 2

A) Correct Correct

B) Correct Incorrect

C) Incorrect Correct

---

Lutz’s first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz’s second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.

Gypsy

One of the basic principles of capital budgeting is that:

A) decisions are based on cash flows, not accounting income.

B) cash flows should be analyzed on a pre-tax basis.

C) opportunity costs should be excluded from the analysis of a project.

---

The five key principles of the capital budgeting process are:

• Decisions are based on cash flows, not accounting income.
• Cash flows are based on opportunity costs.
• The timing of cash flows is important.
• Cash flows are analyzed on an after-tax basis.
• Financing costs are reflected in the project’s required rate of return.

Gypsy

Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting.
Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis.
Statement 2: Cash flows should be analyzed on an after-tax basis.
Should DeWalt agree or disagree with Webb’s statements?

Statement 1

Statement 2

A) Disagree Agree

B) Agree Agree

C) Disagree Disagree

---

DeWalt should disagree with Webb’s first statement. Cash flows are based on opportunity costs. Any cash flows that the firm gives up because a project is undertaken should be charged to the project. DeWalt should agree with Webb’s second statement. The impact of taxes must be considered when analyzing capital budgeting projects.

Gypsy

The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as:

A) opportunity cost; externality.

B) sunk cost; externality.

C) externality; cannibalization.

---

The study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality.

Gypsy

If two projects are mutually exclusive, a company:

A) must accept both projects or reject both projects.

B) can accept one of the projects, both projects, or neither project.

C) can accept either project, but not both projects.

---

Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.

Gypsy

Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm’s optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble?

Sparkle and Fizz

Opportunity to invest in Bubble

A) Independent projects Add-on project

B) Independent projects Project sequencing

C) Mutually exclusive projects Project sequencing

---

Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project’s individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.

Gypsy

The Chief Financial Officer of Large Closeouts Inc. (LCI) determines that the firm must engage in capital rationing for its capital budgeting projects. Which of the following describes the most likely reason for LCI to use capital rationing? LCI:

A) has a limited amount of funds to invest.

B) must choose between projects that compete with one another.

C) would like to arrange projects so that investing in a project today provides the option to accept or reject certain future projects.

---

Capital rationing exists when a company has a fixed (maximum) amount of funds to invest. If profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize its funds to achieve the maximum value for shareholders given its capital limitations.