Estimating Cash Flows
and Analyzing Risk
ANSWERS TO END-OF-CHAPTER QUESTIONS
Since the cost of capital includes a premium for expected inflation, failure to adjust cash
flows means that the denominator, but not the numerator, rises with inflation, and this
lowers the calculated NPV.
Capital budgeting analysis should only include those cash flows which will be affected
by the decision.
Sunk costs are unrecoverable and cannot be changed, so they have no
bearing on the capital budgeting decision. Opportunity costs represent the cash flows the
firm gives up by investing in this project rather than its next best alternative, and
externalities are the cash flows (both positive and negative) to other projects that result
from the firm taking on this project.
These cash flows occur only because the firm took
on the capital budgeting project; therefore, they must be included in the analysis.
When a firm takes on a new capital budgeting project, it typically must increase its
investment in receivables and inventories, over and above the increase in payables and
accruals, thus increasing its net operating working capital.
Since this increase must be
financed, it is included as an outflow in Year 0 of the analysis.
At the end of the project’s
life, inventories are depleted and receivables are collected.
Thus, there is a decrease in
NOWC, which is treated as an inflow.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Initial investment outlay
Operating Cash Flows:
t = 1
Operating income before taxes