Capital budgeting analysis not only requires the evaluation of cash flows but also requires the understanding of the origin of those cash flows. Based on your understanding of cash flows in a firm, answer the following questions:

1. Which of the following is a reason cash flows may differ from accounting income?

a. Depreciation is a tax-deductible expense but is not a cash outlay.

b. The total number of units sold will be different for accounting income and cash flows.

2. Which of the following best describes incremental cash flows?

a. They are the difference between the cash flows the firm will have if it accepts the project versus the cash flows it will have if it rejects the project.

b. Incremental cash flows are not relevant because they will occur whether or not the project is accepted.

Understanding the nature of projects

Capital budgeting analysis often involves decisions related to expansion projects and/or replacement projects. Based on your understanding of expansion and replacement projects, answer the following:

3. If a clothing store opens a second retail location on the other side of town, this project would be considered project.

a. replacement

b. expansion

What are sunk costs?

4. A successful sushi chain in Hong Kong spent $500,000 to conduct a study on whether to open a location in the United States. The study showed that the best place for the company to open their first location would be in Chicago. When conducting its capital budgeting analysis, how should the company account for the cost of the study when estimating the amount of the initial investment that the new store will require?

a. The company should ignore it.

b. The company should include it in the amount of the initial investment.

The role of externalities

5. A large soft-drink company currently produces regular cola and diet cola. It is considering introducing a new soft drink that tastes like regular cola but has zero calories like the diet cola. The new zero-calorie drink that tastes like regular cola is most likely to produce externality.

a. enviromental

b. positive within-firm

c. negative within-firm