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.

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

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

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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

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.

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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

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

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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

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.

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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

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.

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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.