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Explain sunk cost,externality,cannibalization,depreciation

1. Which of the following statements is CORRECT?

a.
A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

b.
A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

c.
A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

d.
Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

e.
A good example of a sunk cost is a situation where a retailer opens a new store, and that leads to a decline in sales of some of the firm's existing stores

2. Which of the following statements is CORRECT?

a.
An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

b.
An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.

c.
The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

d.
Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

e.
The identification of an externality can never lead to an increase in the calculated NPV.

3. Which of the following statements is CORRECT?

a.
If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.

b.
If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.

c.
If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.

d.
If cannibalization is determined to exist, then this means that the calculated NPV considering cannibalization will be higher than the NPV that does not recognize these effects.

e.
Cannibalization is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

4. Which of the following statements is CORRECT?

a.
Using MACRS depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

b.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

c.
Corporations must use the same depreciation method (e.g., straight line or MACRS) for stockholder reporting and tax purposes.

d.
Since depreciation is not a cash expense, it has no affect on cash flows and thus no affect on capital budgeting decisions.

e.
Under MACRS depreciation rules, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

5. Which of the following statements is CORRECT?

a.
Because depreciation is not a cash expense, it plays no role in capital budgeting.

b.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.

c.
Under MACRS depreciation, firms write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

d.
Under MACRS depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

e.
Under MACRS depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

6. Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?

a.
Because the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

b.
If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.

c.
This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.

d.
Because the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.

e.
If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

7. Which of the following is NOT a relevant factor when determining incremental cash flows for a new product?

a.
The use of high quality factory floor space that is currently unused and therefore could be used to produce the proposed new product.

b.
Revenues from an existing product that would be lost as a result of customers switching to the new product.

c.
Shipping and installation costs associated with preparing a machine which would be used to produce the new product.

d.
The cost of a marketing study that was completed last year related to the new product. This research led to the tentative decision to go ahead with the new product, and the cost of the research was expensed for tax purposes last year.

e.
The land which would be used for the new project could be sold to another firm.

8. Which of the following statements is CORRECT?

a.
In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.

b.
In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.

c.
The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.

d.
If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the new project were not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration.

e.
If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

9. Which of the following statements is CORRECT?

a.
Straightforward sensitivity analysis, as it is generally employed, is incomplete in that it fails to consider the range of likely values for the key input variables and the probabilities of different input values.

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 efficiently using a PC with a spreadsheet program or even with just a calculator.

d.
Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.

e.
As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

10. You work for Athens Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow?

Sales revenues
$15,000

Depreciation
$4,000

Other operating costs
$6,000

Tax rate
35.0%

a.
$5,000

b.
$7,250

c.
$7,617

d.
$7,807

e.
$8,003

$2.19