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Chapter 10

Cash Flow and Other Topics in Capital Budgeting

True/False

1. Because installment costs of a new asset are a current cash expense, they are excluded from the initial outlay.

Difficulty: Moderate

Keywords: initial outlay

2. When an old asset is sold for exactly its depreciated value, the only taxable income is the difference between the initial cost of the machine and the selling price.

Difficulty: Moderate

Keywords: selling old asset

3. The capital rationing problem can be correctly solved by ranking projects according to the profitability index.

Difficulty: Moderate

Keywords: capital rationing

4. The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project’s cost.

Difficulty: Easy

Keywords: capital budgeting decision process

5. Working capital for a project includes investment in fixed assets.

Difficulty: Easy

Keywords: working capital

6. The initial outlay involves the immediate cash outflow necessary to purchase the asset and put it in operating order.

Difficulty: Moderate

Keywords: initial outlay

7. When replacing an existing asset, the cash inflow associated with the sale of the old asset and any related tax effects must be considered and accounted for in the analysis.

Difficulty: Moderate

Keywords: replacing asset cash flows

8. In measuring cash flows we are interested only in the incremental or differential after-tax cash flows that are attributed to the investment proposal being evaluated.

Difficulty: Moderate

Keywords: incremental cash flows

9. Cash flows associated with a project’s termination generally include the salvage value of the project plus or minus any taxable gains or losses associated with its sale.

Difficulty: Moderate

Keywords: terminal cash flows

10. Since depreciation is a sunk cost, it is not necessary to consider depreciation in estimating cash flows for a new capital project.

Difficulty: Moderate

Keywords: depreciation expense, sunk cost

11. Projects are said to be mutually exclusive when undertaking one prevents doing the other(s).

Difficulty: Easy

Keywords: mutually exclusive

12. The initial outlay of an asset does not include installation costs.

Difficulty: Moderate

Keywords: initial outlay

13. Additional cash needed to fill increased working capital requirements should be included in the initial cost of a product when analyzing an investment.

Difficulty: Moderate

Keywords: working capital requirements

14. To be conservative, capital budgeting analysis assumes that projects cannot add sales to existing lines of business.

Difficulty: Moderate

Keywords: incremental sales, existing lines of business

15. In making a capital budgeting decision we only include the incremental cash flows resulting from the investment decision.

Difficulty: Moderate

Keywords: incremental cash flows

16. By examining cash flows, we are correctly able to analyze the timing of the benefits.

Difficulty: Moderate

Keywords: timing of cash flows

17. The opportunity cost of using a resource in some way is the amount the resource could earn if used in an alternative way.

Difficulty: Moderate

Keywords: opportunity cost

18. If the firm decides to impose a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects that has the highest net present value subject to the capital constraint.

Difficulty: Moderate

Keywords: capital rationing

19. The size disparity problem occurs when extremely large mutually exclusive projects are being examined.

Difficulty: Moderate

Keywords: mutually exclusive projects

20. Capital rationing can occur when profitable projects must be rejected because of shortage of capital.

Difficulty: Moderate

Keywords: capital rationing

21. A financial manager had his choice between two mutually exclusive investments, one with a distribution skewed to the right and one with a distribution skewed to the left. Both distributions have the same expected value and same standard deviation. The financial manager would prefer the one skewed to the left.

Difficulty: Moderate

Keywords: mutually exclusive projects

22. A project’s equivalent annual annuity (EAA) is calculated by dividing the project’s NPV by the PVIFAi,n where i is the appropriate discount rate and n is the project’s life.

Difficulty: Moderate

Keywords: equivalent annual annuity

23. A project’s equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value as the project’s NPV.

Difficulty: Moderate

Keywords: equivalent annual annuity

24. An infinite life replacement chain allows projects of different length lives to be compared.

Difficulty: Moderate

Keywords: infinite replacement chain

25. In selecting projects when there is capital rationing, the payback period method should be used.

Difficulty: Moderate

Keywords: capital rationing

26. Accounting profits represents free cash flows that are available for reinvestment.

Difficulty: Easy

Keywords: accounting profits, free cash flows

27. Working capital requirements are considered a cash flow even though they do not leave the company.

Difficulty: Moderate

Keywords: working capital requirements

28. Sunk costs are a type of incremental cash flow that should be included in all capital-budgeting decisions.

Difficulty: Moderate

Keywords: sunk costs

29. The pertinent issue for determining whether overhead costs should be part of a project’s relevant after-tax cash flow is whether the project benefits from the overhead items.

Difficulty: Moderate

Keywords: overhead

30. The hardest step in capital budgeting analysis is calculating the cash flows of a project.

Difficulty: Moderate

Keywords: cash flow calculations

31. Since depreciation is a non-cash expense, it should not be included as part of a project’s relevant after-tax cash flow.

Difficulty: Moderate

Keywords: depreciation expense

32. A marketing survey completed last year to determine a project’s feasibility would be included as part of the project’s initial cash outflow.

Difficulty: Moderate

Keywords: relevant cash flows, sunk costs

33. Expenses incurred to install an asset are part of the asset’s initial cash outflow.

Difficulty: Moderate

Keywords: initial outlay

34. Sales captured from the firm’s competitors can be relevant to the capital-budgeting decision.

Difficulty: Moderate

Keywords: lost sales

35. Any capital rationing that rejects projects with positive net present values is contrary to the firm’s goal of shareholder wealth maximization.

Difficulty: Moderate

Keywords: capital rationing

36. NPV and IRR can provide ranking inconsistencies when projects have unequal lives.

Difficulty: Moderate

Keywords: project ranking

Multiple Choice

37. Incremental cash flows include all of the following EXCEPT:

a. labor and material savings.

b. sunk costs.

c. interest to bondholders.

d. both b & c.

Difficulty: Easy

Keywords: incremental cash flows

38. The net present value always provides the correct decision provided that:

a. cash flows are constant over the asset’s life.

b. the required rate of return is greater than the internal rate of return.

c. capital rationing is not imposed.

d. the internal rate of return is positive.

Difficulty: Moderate

Keywords: capital rationing and NPV

39. If the federal income tax rate were increased, the result would be an increase in the:

a. discounted payback period.

b. internal rate of return.

c. net present value.

d. profitability index.

Difficulty: Easy

Keywords: discounted payback period, taxes

40. Which of the following techniques may not consider ALL cash flows of a project?

a. Net present value

b. Internal rate of return

c. Payback period

d. Modified internal rate of return

Difficulty: Easy

Keywords: payback period

41. Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal?

a. Training expense

b. Working capital investments

c. Installation costs of an asset

d. Before-tax selling price of old machine

Difficulty: Moderate

Keywords: initial outlay

42. Which of the following is not considered in the calculation of incremental cash flows?

a. Depreciation tax shield

b. Sunk costs

c. Opportunity costs

d. Both a & b

Difficulty: Moderate

Keywords: sunk costs

43. If the federal income tax rate were increased, the impact of the tax increase on acceptable investment proposals would be to (ignore the impact of the tax change on the cost of capital) decrease the:

a. net present value.

b. internal rate of return.

1. payback period.
2. both a & b.

e. all of the above.

Difficulty: Moderate

Keywords: incremental cash flows

44. Which of the following would increase the net working capital for a project? An increase in:

a. accounts receivable.

b. fixed assets.

c. accounts payable.

d. common stock.

Difficulty: Moderate

Keywords: net working capital

45. Which of the following should be included in the initial outlay?

a. Shipping and installation costs

b. Increased working capital requirements

c. Cost of employee training associated specifically with the asset being evaluated

d. All of the above

Difficulty: Moderate

Keywords: initial outlay

46. Depreciation expenses affect capital budgeting analysis by increasing

a. taxes paid.

b. incremental cash flows.

c. the initial outlay.

d. working capital.

Difficulty: Easy

Keywords: incremental cash flows, depreciation expense

47. Which of the following is included in the terminal cash flow?

a. The expected salvage value of the asset

b. Tax impacts from selling asset

c. Recapture of any working capital

d. All of the above

Difficulty: Easy

Keywords: terminal cash flow

48. A firm purchased an asset with a 5-year life for $90,000, and it cost $10,000 for shipping and installation. According to the current tax laws the cost basis of the asset is:

a. $100,000.

b. $95,000.

c. $80,000.

d. $70,000.

Difficulty: Easy

Keywords: cost basis of asset, initial outlay

49. XYZ, Inc. is considering adding a product line that would utilize unused floor place of their manufacturing plant. The floor space would be considered a(n):

a. variable cost.
b. opportunity cost.
c. sunk cost.
d. irrelevant cash flow.

Difficulty: Moderate

Keywords: opportunity cost

50. Which of the following is included in the calculation of the initial outlay for a capital investment?

a. Investment in working capital

b. Shipping expenses

c. Installation

d. All of the above

Difficulty: Moderate

Keywords: initial outlay

51. Which of the following would decrease free cash flows? A decrease in:

a. depreciation expense.

b. interest expense.

c. incremental sales.

d. both a & c.

e. all of the above.

Difficulty: Moderate

Keywords: free cash flows

52. Your company is considering replacing an old steel cutting machine with a new one. Two months ago, you sent the company engineer to a training seminar demonstrating the new machine’s operation and efficiency. The $2,500 cost for this training session has already been paid. If the new machine is purchased, it would require $5,000 in installation and modification costs to make it suitable for operation in your factory. The old machine originally cost $50,000 five years ago and is being depreciated by $7,000 per year. The new machine will cost $75,000 before installation and modification. It will be depreciated by $5,000 per year. The old machine can be sold today for $10,000. The marginal tax rate for the firm is 40%. Compute the relevant initial outlay in this capital budgeting decision.

a. $72,500

b. $68,000

c. $70,500

d. $78,000

Difficulty: Hard

Keywords: initial outlay

53. Burr Habit Corporation is considering a new product line. The company currently manufactures several lines of snow skiing apparel. The new products, insulated ski shorts, are expected to generate sales less cost of goods sold of $1 million per year for the next five years. They expect that during this five year period, they will lose about $250,000 per year in sales less cost of goods sold on their existing lines of longer ski pants as a result of the introduction of the new product line. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the existing apparel products. The new project will, however, require that the company spend an additional $80,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year in salary and benefits. Because of the different construction of the shorts, an increase in inventory of 3,800 would be required initially. If the marginal tax rate is 30%, compute the incremental after tax cash flows for year 1-5.

a. $434,500 per year

b. $625,000 per year

c. $187,500 per year

d. $437,500 per year

Difficulty: Hard

Keywords: incremental cash flow

54. Al’s Fabrication Shop is purchasing a new rivet machine to replace an existing one. The new machine costs $8,000 and will require an additional cost of $1,000 for modification and training. It will be depreciated using simplified straight line depreciation over five years. The new machine operates much faster than the old machine and with better quality. Consequently, sales are expected to increase by $2,100 per year for the next five years. While it is faster, it is fully automated and will result in increased electricity costs for the firm by $700 per year. It will, however, save about $850 per year in labor costs. The old machine is 20 years old and has already been fully depreciated. If the firm’s marginal tax rate is 28%, compute the after tax incremental cash flows for the new machine for years 1 through 5.

a. $2,698

b. $450

c. $2,124

d. $1,620

Difficult: Hard

Keywords: incremental cash flow

55. National Geographic is replacing an old printing press with a new one. The old press is being sold for $350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40% income tax bracket. How much will National Geographic pay in income taxes from the sale?

a. $140,000

b. $45,000

c. $110,000

d. $87,010

Difficulty: Moderate

Keywords: tax on sale of asset

56. National Geographic is replacing an old printing press with a new one. The old press is being sold for $350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40% income tax bracket. How much will National Geographic net from the sale?

a. $315,000

b. $112,112

c. $240,000

d. $116,050

Difficulty: Moderate

Keywords: sale of asset

57. Crawfish Kitchen Inc. is planning to invest in one of three mutually exclusive projects. Projected cash flows for these ventures are as follows:

Which project is the most profitable according to the NPV Criteria if the discount rate for the firm is 14%?

a. Plan A

b. Plan B

c. Plan C

Difficulty: Moderate

Keywords: mutually exclusive projects

58. What is the capital budgeting term that is used to refer to more than one investment alternative that performs the same function?

a. Simulated

b. Capital rationed

c. Mutually exclusive

d. Opportunistic

Difficulty: Moderate

Keywords: mutually exclusive

59. Which of the following income or expense items should be rejected when estimating cash flows for investment projects?

a. Incremental sales

b. Opportunity costs

c. Financing costs

d. Operating expenses

Difficulty: Moderate

Keywords: financing costs

60. Which of the following expenses should be included when estimating cash flows for investment projects?

a. Interest expense related to financing a project

b. Sunk costs

c. Required principal payments related to financing a project

d. Opportunity costs

Difficulty: Moderate

Keywords: opportunity costs

61. Capital rationing may be imposed because:

a. capital market conditions are poor.

b. of management’s fear of debt.

c. stockholder control problems prevent issuance of additional stock.

d. all of the above.

Difficulty: Moderate

Keywords: capital rationing

62. When selecting the best project from a group of mutually exclusive projects you should choose the project with the highest:

a. net present value.

b. internal rate of return.

c. accounting rate of return.

d. payback.

Difficulty: Moderate

Keywords: mutually exclusive

63. The most common method of solving the unequal life problem is:

a. to create a replacement chain to equalize the life span.

b. to assume that the cash inflows from the shorter-lived investment will be reinvested at the cost of capital until the termination of the longer-lived investment.

c. to project future cash flows from reinvestment opportunities in the future from the cash flows generated by the shorter-lived investment.

d. none of the above.

Difficulty: Moderate

Keywords: unequal lives

64. If a company decides that it needs to impose capital rationing, which statement is true?

a. The effect is positive if adverse economic conditions exist.

b. The effect is positive if there is a shortage of effective managers within the firm to manage the project.

c. The effect is negative because the process involves rejecting a project with a positive net present value, which in turn fails to maximize shareholders’ wealth.

d. The effect is negative because it results from a manager’s fear of risk.

Difficulty: Moderate

Keywords: capital rationing

65. You are in charge of one division of Bigfella Conglomerate Inc. Your division is subject to capital rationing. Your division has four indivisible projects available, detailed as follows:

Project Initial Outlay IRR NPV

1 2 million 18% 2,500,000

2 1 million 15% 950,000

3 1 million 10% 600,000

4 3 million 9% 2,000,000

If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should be accepted so as to maximize firm value?

a. Projects 1, 2, and 3

b. Project 1 only

c. Projects 1 and 4

d. Projects 2, 3, and 4

Difficulty: Moderate

Keywords: capital rationing

66. Your company is considering an investment in one of two mutually exclusive projects. Project 1 involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax cash flows of $500 per year in years 1-5. Project 2 involves a capital intensive process, requiring an initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5. Your firm’s discount rate is 10%. If your company is not subject to capital rationing, which project(s) should you take on based on the basic capital budgeting criteria (NPV and IRR)?

a. Project 1

b. Project 2

c. Projects 1 and 2

d. Neither project is acceptable.

Difficulty: Moderate

Keywords: mutually exclusive

67. Regal Enterprises is considering the purchase of a new embroidering machine. It is expected to generate additional sales of $400,000 per year. The machine will cost $295,000, plus $3,000 to install it. The embroiderer will save $12,000 in labor expense each year. Regal is in the 34% income tax bracket. The machine will be depreciated on a straight-line basis over five years (it has no salvage value). The embroiderer will require annual operating expenses of $136,000. What is the annual operating cash flow that the machine will generate?

a. $316,954

b. $124,000

c. $202,424

d. $165,816

Difficulty: Moderate

Keywords: incremental cash flow

68. Mr. Smith included the cost of test marketing before production in the calculation of the initial outlay. Apparently, Mr. Smith does not understand the concept of:

a. side-effect costs.
b. opportunity costs.
c. sunk costs.
d. variable costs.

Difficulty: Easy

Keywords: sunk costs

69. Your firm is considering investing in one of two mutually exclusive projects. Project A requires an initial outlay of $2,500 with expected future cash flows of $1,150 per year for the next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of $1,577 per year for the next two years. The appropriate discount rate for your firm is 14%, and it is not subject to capital rationing. Assuming both projects can be replaced with a similar investment at the end of their respective lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project B.

a. $170, $197

b. $472, $463

c. $285, $229

d. $528, $568

Difficulty: Moderate

Keywords: replacement chain

70. Determine the dollar value of a three year annuity that would produce the same NPV as the following project if the appropriate discount rate is 15%, and initial outflow = 0.

Initial Outflow = $1,200

Cash Flow Year 1 = $800

Cash Flow Year 2 = $500

Cash Flow Year 3 = $700

a. $250.38

b. $673.94

c. $146.28

d. $430.82

Difficulty: Moderate

Keywords: equivalent annuity

71. In general, what effect does capital rationing have on firm value?

a. It increases firm value.

b. It decreases firm value.

c. It can increase or decrease firm value.

d. It has no impact on firm value.

Difficulty: Moderate

Keywords: capital rationing

72. Relevant incremental cash flows include:

a. sales captured from the firm’s competitors.

b. retained sales that would have been lost to new competing products.

c. incremental sales brought to the firm as a whole.

d. all of the above.

Difficulty: Moderate

Keywords: relevant cash flows

73. Which of the following is not one of the categories for a project’s relevant after-tax cash flows?

a. Financing flows

b. Initial cash outflow

c. Differential flows over the project’s life

d. Terminal cash flow

Difficulty: Moderate

Keywords: relevant cash flows

74. Which of the following is not part of a project’s initial cash outflow?

a. The asset’s purchase price

b. Funds committed to support increased inventory levels due to expected increased sales if the firm adopts the project

c. A marketing survey completed last year to determine the project’s feasibility

d. Expenses incurred to install the asset

Difficulty: Moderate

Keywords: initial outlay

Use the following information to answer questions 75–79. Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000 in addition to increasing non-depreciation expenses by $3,000 annually. Due to the sales increase, Delta expects its working capital to increase $1,000 during the life of the project. Delta will depreciate the machine using the straight-line method over the project’s five year life to a salvage value of zero. The machine’s purchase price is $20,000. The firm has a marginal tax rate of 34 percent, and its required rate of return is 12 percent.

75. The machine’s initial cash outflow is:

a. $20,000.

b. $21,000.

c. $27,000.

d. $23,000.

Difficulty: Moderate

Keywords: initial outlay

76. The machine’s incremental after-tax cash inflow is:

a. $6,420.

b. $7,980.

c. $8,620.

d. $5,980.

Difficulty: Moderate

Keywords: incremental cash flow

77. The machine’s after-tax incremental cash flow in year five is:

a. $6,980.

b. $5,980.

c. $7,120.

d. $8,620.

Difficulty: Moderate

Keywords: incremental cash flow

78. The machine’s NPV is:

a. $1,556.56.

b. $2,556.56.

c. $1,123.99.

d. $2,123.99.

Difficulty: Moderate

Keywords: net present value

79. The machine’s IRR is:

a. less than 0.

b. greater than 12 percent.

c. less than 12 percent.

d. equal to 12 percent.

Difficulty: Moderate

Keywords: internal rate of return

80. ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for $600,000. What is the depreciable cost basis of the machine?

a. $3,025,000

b. $2,950,000

c. $2,575,000

d. $2,350,000

Difficulty: Moderate

Keywords: depreciable cost basis

81. ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for $600,000. What is the total investment amount required for the machine?

a. $3,025,000

b. $2,950,000

c. $2,575,000

d. $2,350,000

Difficulty: Moderate

Keywords: initial outlay

82. ABC will purchase a machine that will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. ABC plans to depreciate the machine by using the straight-line method. The machine is expected to increase ABC’s sales revenues by $1,890,000 per year; operating costs excluding depreciation are estimated at $454,600 per year. Assume that the firm’s tax rate is 40%. What is the annual operating cash flow?

a. $922,464

b. $1,126,287

c. $813,563

d. $1,029,811

Difficulty: Moderate

Keywords: operating cash flow, incremental cash flow

83. ABC purchased a machine for $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after-which it will be sold for $600,000. ABC plans to depreciate the machine by using the straight-line method. Assume that the firm’s tax rate is 40%. What is the termination (non-operating) cash flow from the machine in year three?

a. $900,623

b. $1,109,286

c. $1,298,114

d. $879,247

Difficulty: Moderate

Keywords: terminal cash flow

84. Famous Danish Corp. is replacing an old cookie cutter with a new one. The cookie cutter is being sold for $25,000 and it has a net book value of $75,000. Assume that Famous Danish is in the 34% income tax bracket. How much will Famous Danish net from the sale?

a. $61,000

b. $55,000

c. $75,000

d. $42,000

Difficulty: Moderate

Keywords: sale of asset cash flow

Use the following information to answer questions 85-91. A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the straight-line method. The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital during the asset’s life of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago for $25,000, has a remaining life of five years, and is being depreciated using the straight-line method. The expected salvage value at the end of the asset’s life (i.e., five years from now) is $5,000; however, the current sale price of the existing asset is $20,000, and its current book value is $15,625. The firm’s marginal tax rate is 34 percent and its required rate of return is 12 percent.

85. Increased taxes on the sale of the old machine are:

a. $1,487.50.

b. $2,500.50.

c. $3,823.50.

d. $4,312.50.

Difficulty: Moderate

Keywords: sale of asset cash flow

86. The net initial outlay if the new asset is purchased is:

a. $34,487.50.

b. $54,500.50.

c. $35,987.50.

d. $37,687.50.

Difficulty: Moderate

Keywords: initial outlay

87. The incremental change in depreciation is:

a. $9,650.

b. $10,625.

c. $7,475.

d. $8,100.

Difficulty: Moderate

Keywords: incremental depreciation

88. The net incremental after-tax cash flow is:

a. $13,504.00.

b. $13,761.50.

c. $14,824.00.

d. $12,441.50.

Difficulty: Moderate

Keywords: incremental cash flow

89. The after-tax terminal cash flow is:

a. $14,601.50.

b. $13,101.50.

c. $13,941.50.

d. $14,941.50.

Difficulty: Moderate

Keywords: terminal cash flow

90. The NPV for this replacement decision is:

a. $11,586.97.

b. $10,086.97.

c. $10,735.82.

d. $10,279.89.

Difficulty: Moderate

Keywords: net present value, replacement project

91. The IRR for this replacement decision is:

a. less than zero.

b. equal to 12 percent.

c. less than 12 percent.

d. greater than 12 percent.

Difficulty: Moderate

Keywords: internal rate of return, replacement project

92. Problems in project ranking can occur due to:

a. size disparity.

b. time disparity.

c. unequal project lives.

d. all of the above.

Difficulty: Moderate

Keywords: project ranking

Use the following information to answer questions 93-97. You are trying to determine which of two projects to undertake. Both projects have an initial outlay of $2,000. However, Project Y provides an after-tax cash flow of $1,000 each year for three years, while Project Z provides an after-tax cash flow of $600 each year for six years. The required rate of return for both projects is 10 percent. Therefore, Project Y has an NPV of $486.85 and an IRR of 23.38 percent, and Project Z has an NPV of $613.16 and an IRR of 19.91.

93. The equivalent annual annuity for Project Y is:

a. $186.85.

b. $162.28.

c. $195.76.

d. $111.79.

Difficulty: Moderate

Keywords: equivalent annual annuity

94. The equivalent annual annuity for Project Z is:

a. $204.32.

b. $102.19.

c. $246.55.

d. $140.79.

Difficulty: Moderate

Keywords: equivalent annual annuity

95. The infinite-life replacement chain for Project Y is:

a. $1,957.60.

b. $1,407.90.

c. $1,868.50.

d. $1,673.90.

Difficulty: Moderate

Keywords: infinite-life replacement chain

96. The infinite-life replacement chain for Project Z is:

a. $1,957.60.

b. $1,407.90.

c. $1,868.50.

d. $1,657.90.

Difficulty: Moderate

Keywords: infinite-life replacement chain

97. Based on the information, you would:

a. choose Project Z because it has the highest NPV.

b. choose Project Y because it has the highest EAA and infinite-life replacement chain.

c. choose Project Z because it has the highest IRR.

d. choose neither project due to the discrepancy in rankings.

Difficulty: Moderate

Keywords: project selection

98. Which of the following best describes why cash flows are utilized rather than accounting profits when evaluating capital projects?

a. Cash flows have a greater present value than accounting profits.

b. Cash flows reflect the timing of benefits and costs more accurately than accounting profits.

c. Cash flows are more stable than accounting profits.

d. Cash flows improve the tax position of a firm more than accounting profits.

e. None of the above.

Difficulty: Moderate

Keywords: cash flows

99. Which of the following is the best example of an incremental cash inflow/outflow?

a. Cash flows that are achieved by diverting sales from other projects of the firm

b. Cash flows that are associated with the financing of a project

c. Cash flows that occur a little at a time

d. What the cash flows will be if the project is undertaken as opposed to what they would have been if the project had not been undertaken

e. None of the above

Difficulty: Moderate

Keywords: cash flows

100. Which of the following is an example of a sunk cost?

a. Overhead costs that are associated with a project.

b. Interest expense associated with a project.

c. Market study expenses incurred in order to decide if a firm should accept a project.

d. Income taxes associated with a project.

e. Depreciation expenses associated with a project.

Difficulty: Moderate

Keywords: sunk cost

101. Which of the following cash flows should be included as incremental costs when evaluating capital projects?

a. Overhead expenses that are directly related to a project.

b. Interest expense that is directly related to the financing of a project.

c. Sunk costs that are related to a project.

d. Principal payments that are directly related to the financing of a project.

Difficulty: Moderate

Keywords: incremental cash flow

102. Which of the following cash flows should be included as incremental costs when evaluating capital projects?

a. Investment in working capital that is directly related to a project

b. Expenses that are incurred in order to modify a firm’s production facility in order to invest in a project

c. Overhead expenses that are directly related to a project

d. Opportunity costs that are directly related to a project

e. All of the above

Difficulty: Moderate

Keywords: incremental costs

103. How is interest expense that is associated with a project treated in the capital budgeting process?

a. It is treated as a cash outflow when estimating the incremental cash flows associated with a project.

b. It is built into the discount rate.

c. It is considered a synergistic incremental cash flow.

d. Interest expense is not relevant to any capital budgeting decisions.

Difficulty: Moderate

Keywords: financing costs

104. The calculation of differential cash flows over a project’s life should include which of the following?

a. Labor and material savings

b. Additional revenues

c. Investment in net working capital

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: incremental cash flows

105. Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal?

a. Increase in accounts receivable

b. The cost of shipping new equipment

c. The cost of issuing new bonds if the project is financed by a new bond issue

d. The cost of installing new equipment

e. All of the above should be considered.

Difficulty: Moderate

Keywords: initial outlay

106. Depreciation expenses affect tax-related cash flows by:

a. increasing taxable income, thus increasing taxes.

b. decreasing taxable income, thus reducing taxes.

c. decreasing taxable income, but not altering cash flows since depreciation is not a cash expense.

d. all of the above.

e. none of the above.

Difficulty: Moderate

Keywords: depreciation expense

107. Which of the following will increase free cash flow?

a. A decrease in interest expense

b. An increase in depreciation expense

c. A decrease in net working capital needs

d. Both a & c

Difficulty: Moderate

Keywords: free cash flow

108. Which of the following would be considered a termination cash flow?

a. The expected salvage value of the asset

b. Any tax payments or refunds associated with the salvage value of the asset

c. Recapture of any investment in working capital that was included as an incremental cash outlay

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: terminal cash flow

109. The placing of a limit by the firm on the dollar size of the capital budget is referred to as:

a. capital rationing.

b. the reinvestment rate assumption.

c. size disparity.

d. unequal lives.

Difficulty: Easy

Keywords: capital rationing

110. When determining the initial cash outlay of an asset that is being replaced, which of the following should be included?

a. Interest expense that is directly related to the financing of a project

b. The pre-tax sales proceeds of the asset being sold

c. Market study expenses that were incurred in order to decide if the firm should accept a project

d. Principal payments that are directly related to the financing of a project

e. The sales proceeds of the asset being sold, net of any income taxes related to the sale

Difficulty: Moderate

Keywords: replacement of asset

111. What would cause the initial cash outlay of an investment decision to be affected by the sale of an existing asset?

a. If the investment decision is a replacement decision

b. If the asset being purchased is technologically superior

c. If the asset being sold has exceeded its MACR’s recovery allowance period

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: initial outlay

112. Which of the following would cause book profit to differ from cash flow when an investment project is terminated?

a. Goodwill

b. Recovery of net working capital

c. Income taxes

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: net working capital

113. Which of the following should be considered in the estimation of termination cash flows?

a. Cash generated from the sale of a project

b. Recovery of net working capital

c. Income taxes associated with the sale of a project

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: terminal cash flow

114. The Board of Directors of Waste Free Chemicals is considering the acquisition of a new chemical processor. The processor is priced at $600,000 but would require $60,000 in transportation costs and $40,000 for installation. The processor will have a useful life of 10 years. The project will require Waste Free to increase its investment in accounts receivable by $80,000 and will also require an additional investment in inventory of $150,000. The firm’s marginal tax rate is 40 percent. How much is the initial cash outlay of the processor?

a. $700,000

b. $850,000

c. $930,000

d. $1,040,000

Difficulty: Moderate

Keywords: initial outlay

115. The Director of Capital Budgeting of Capital Assets Corp. is considering the acquisition of a new high speed photocopy machine. The photocopy machine is priced at $85,000 and would require $2,000 in transportation costs and $4,000 for installation. The equipment will have a useful life of 5 years. The proposal will require that Capital Assets Corp. send technician for training at a cost of $5,000. The firm’s marginal tax rate is 40 percent. How much is the initial cash outlay of the photocopy machine?

a. $58,600

b. $64,000

c. $77,000

d. $81,000

e. $96,000

Difficulty: Moderate

Keywords: initial outlay

116. Jefferson Corporation is considering an expansion project. The necessary equipment could be purchased for $15 million and shipping and installation costs are another $500,000. The project will also require an initial $2 million investment in net working capital. The company’s tax rate is 40%. What is the project’s initial investment outlay (in millions)?

a. $15.0

b. $15.5

c. $16.5

d. $17.0

e. $17.5

Difficulty: Moderate

Keywords: initial outlay

117. Wright’s Warehouse has the following projections for Year 1 of a capital budgeting project.

Year 1 Incremental Projections:

Sales $200,000

Variable Costs $120,000
Fixed Costs $40,000

Depreciation Expense $20,000

Tax Rate 40%

Calculate the operating cash flow for Year 1.

a. $12,000

1. $32,000
2. $52,000
3. $72,000

Difficulty: Hard

Keywords: operating cash flow

118. SpaceTech is considering a new project with the following projections for Year 2.

Year 2 Projections

EBIT $400,000

Interest Expense $20,000
Depreciation Expense $40,000

Tax Rate 40%

Net Working Capital Needs $200,000

If the projected net working capital needs for Year 1 was $150,000, calculate the free cash flow for Year 2.

a. $130,000

1. $180,000
2. $230,000
3. $280,000

Difficulty: Hard

Keywords: free cash flow

119. Holding all other variables constant, which of the following will increase the equivalent annual annuity for a given project? An increase in the:

a. net present value.

b. payback Period.

c. discount rate.

d. both a and c.

Difficulty: Easy

Keywords: equivalent annual annuity

120. When evaluating Capital Budgeting decisions, which of the following items should not be included in the construction of cash flow projections for purposes of analysis?

a. Annual sales

b. Fixed expenses

c. Changes in net working capital requirements

d. Sunk costs

e. All of the above should be included

Difficulty: Moderate

Keywords: sunk costs

121. When evaluating Capital Budgeting decisions, which of the following items should not be included in the construction of cash flow projections for purposes of analysis?

a. Net salvage value

b. Land and building expenses

c. Changes in net working capital requirements

d. Shipping and installation costs

e. All of the above should be included.

Difficulty: Moderate

Keywords: project cash flows

122. Holding all other variables constant, which of the following would INCREASE net working capital for given year on a project?

a. Allowing customers less time to pay for purchases

b. Taking longer to pay suppliers

c. Increasing inventory levels

d. Both a and c

Difficulty: Moderate

Keywords: net working capital requirements

123. If an investment project would make use of land which the firm currently owns, the project should be charged with:

a. a sunk cost.

b. an opportunity cost.

c. amortization.

d. interest.

e. abuse of power.

Difficulty: Moderate

Keywords: opportunity cost

124. Which of the following methods allows for the proper comparison of two projects that have entirely different useful lives?

a. Net present value

b. Equivalent annual annuity

c. Payback

d. Internal rate of return

Difficulty: Moderate

Keywords: equivalent annual annuity

125. Harbor Town Corp. is considering the purchase of a machine. Two alternatives have been isolated. The firm’s discount rate is 12.5%. Machine A has a net present value of $265,000 and a useful life of 5 years. Machine B has a net present value of $97,500 and a useful life of ears. What is Machine A’s Equivalent Annual Annuity?

a. $55,821

b. $74,426

c. $37,512

d. $22,318

Difficulty: Moderate

Keywords: equivalent annual annuity

126. Harbor Town Corp. is considering the purchase of a machine. Two alternatives have been isolated. The firm’s discount rate is 12.5%. Machine A has a net present value of $265,000 and a useful life of 5 years. Machine B has a net present value of $97,500 and a useful life of 3 years. What is Machine B’s Equivalent Annual Annuity?

a. $40,943

b. $55,538

c. $62,826

d. $91,391

Difficulty: Moderate

Keywords: equivalent annual annuity

Short Answer

127. Discuss the reasons that NPV and IRR can lead to different project rankings.

Difficulty: Moderate

Keywords: conflicts project ranking

128. Consider the following two projects:

Initial Net Cash flow Each Period

Outlay

1 2 3 4

Project A $4,000 $2,003 $2,003 $2,003 $ 2,003

Project B $4,000 $10,736

Calculate the net present value of each of the above projects, assuming a 14 percent discount rate.

At a discount rate of 14 percent:

NPVA = $2,003(2.914) - $4,000

NPVA = $1,836.74

NPVB = $10,736(.592) - $4,000

NPVB = $2,355.71

Difficulty: Moderate

Keywords: project evaluation

129. Consider two mutually exclusive projects X and Y with identical initial outlays of $90,000 and depreciable lives of 5 years. Project X is expected to produce free cash flows of $32,787 each year. Project Y is expected to generate a single after-tax net cash flow of $223,880 in year 5. The cost of capital is 15 percent.

a. Calculate the net present value for each project.

b. Calculate the IRR for each project.

c. What problem(s) do you foresee in selecting one of the projects?

d. What project should be selected?

a. NPVX = $32,787 × 3.352 - $90,000

NPVX = $19,902

NPVY = $223,880 × .497 - $90,000

NPVY = $21,268

b. IRRX

$90,000 = 32,787 PVIFA[IRR%, 5 yr.]

2.745 = PVIFA[IRR%, 5 yr.]

24% = IRRX

IRRY

90,000 = 223,880 PVIF[IRR%, 5 yr.]

.402 = PVIF[IRR%, 5 yr.]

20% = IRRY

c. There is a conflict in the rankings of the projects.

Project NPV(15%) IRR

X $19,902 24%

Y $21,268 20%

d. Select Project Y because it has the highest NPV.

Difficulty: Moderate

Keywords: mutually exclusive, ranking conflicts

130. Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be fully depreciated by the simplified straight line method over its 5 year depreciable life. Operating costs of the new machine are expected to be $1,100,000 per year. The existing assembly line has 5 years remaining before it will be fully depreciated and has a book value of $3,000,000. If sold today the company would receive $2,400,000 for the existing machine. Annual operating costs on the existing machine are $2,100,000 per year. Bull Gator is in the 46 percent marginal tax bracket and has a required rate of return of 12 percent.

a. Calculate the net present value of replacing the existing machine.

b. Explain the impact on NPV of the following:

i. Required rate of return increases

ii. Operating costs of new machine are increased

iii. Existing machine sold for less

a. Calculate Initial Outlay

Purchase Price $6,000,000

Sale of old (2,400,000)

Tax savings from sale

($3,000,000 - 2,400,000).46 (276,000)

Initial Outlay $3,324,000

Free Cash Flows

Change in EBDIT $1,000,000

-Increased Depreciation - 600,000

Change in EBIT $400,000

-Taxes (at 46%) - 184,000

+Change in Depreciation + 600,000

-Change in Working Capital - 0

-Change in Capital Spending - 0

$ 816,000

Depreciation on old machine

$3,000,000/5 = $600,000

Depreciation on new machine

$6,000,000/5 = $1,200,000

Increase Depreciation

= $600,000 - $1,200,000 = -$600,000

Calculate NPV

NPV = $816,000 × 3.605 - $3,324,000

NPV = -$382,320

b. i. NPV decreases

ii. NPV decreases

iii. NPV decreases

Difficulty: Hard

Keywords: project cash flows

131. AFX Industries purchased some agricultural land at the edge of a large metropolitan area for $200,000 five years ago. In order to have the land classified as agricultural for property tax purposes, the company has been leasing the property to neighboring farmers. The increased EBIT (there is no change in depreciation) from leasing the property is $8,000 per year. This company’s corporate tax rate is 46 percent. If the company sells the land for $300,000 today, what is the internal rate of return on this investment?

Initial investment at time 0 = $200,000

Free cash flows time 1–4 = (1 - .46)($8,000) = $4,320

Terminal after-tax cash flow time 5

$4,320 + $300,000 – (.46)($300,000 - $200,000) = $258,320

$200,000 = $4,320 PVIFA [IRR%, 4 yr]

+ $258,320 PVIF [IRR%, 5 yr]

IRR = 6.867%

Difficulty: Moderate

Keywords: project analysis, internal rate of return

132. Patrick Motors has several investment projects under consideration, all with positive net present values. However, due to a shortage of trained personnel, a limit of $1,250,000 has been placed on the capital budget for this year. Which of the projects listed below should be included in this year’s capital budget?

Project Initial Outlay NPV

A $ 250,000 $325,000

B 250,000 350,000

C 1,000,000 700,000

D 375,000 112,500

E 375,000 75,000

Project P.I.

A 2.3

B 2.4

C 1.7

D 1.3

E 1.2

Select combination with highest NPV or PI

Ex. (1) NPV (A + B + D + E) = $862,500

or PI (A + B + D + E) = 1.69

(2) NPV (C + B) = $1,050,000

or PI (C + B) = 1.84

Projects B and C should be selected.

Difficulty: Moderate

Keywords: capital rationing

133. Describe the ways that conflicts in project rankings can be addressed.

There are two ways to address the issues that cause conflicts in project rankings. The first method is the replacement chain approach. This approach allows projects with uneven lives to be replicated until a common number of years has been established. Once the cash flows have been replicated, NPV is calculated to determine which project creates the best value. The project with the highest NPV is selected.

The second method is the equivalent annuity approach. In this approach, the NPV is solved all projects being analyzed. An annual cash flow is calculated, i.e. annuity, that yields the same present value as the NPV. The project with the highest annuity payment is selected.

Difficulty: Moderate

Keywords: conflicts in project rankings

134. Two mutually exclusive projects are being evaluated using the accounting rate of return. Each project has an initial outlay of $50,000 and salvage value of $10,000 after six years. The after-tax profits for the two projects are:

Year Profit A Profit B

1 $5,000 $25,000

2 5,000 25,000

3 5,000 25,000

4 32,500 12,500

5 32,500 12,500

6 35,000 12,500

a. Calculate each project’s AROR.

b. Which project should be selected using this criterion? Do you

support the recommendation? Why or why not?

Average investment = ($50,000 + $10,000)/2 = $30,000

Average Profit for Project A = $19,167

1/6($5,000 + $5,000 + $5,000 + $32,500 + $32,500 + $35,000)

Average Profit for Project B = $18,750

1/6(3 × $25,000 + 3 × $12,500)

a. ARORA = $19,167/$30,000 = 63.9%

ARORB = 18,750/$30,000 = 62.5%

b. Project A has a slightly higher AROR. However, the internal rate of

return for Project A is 22.3% while the internal rate of return for

Project B is 37.9%.

Difficulty: Moderate

Keywords: accounting rate of return

135. The Deacon Company is considering two mutually exclusive projects with depreciable lives of three and six years. The after-tax cash flows for projects S and L are listed below.

Year Cash Flow S Cash Flow L

0 -$50,000 -$50,000

1 25,625 16,563

2 25,625 16,563

3 25,625 16,563

4 16,563

5 16,563

6 16,563

The required rate of return on these projects is 15 percent. Which project should be accepted?

Calculate net present values

NPVS = $25,625 × 2.283 - $50,000

NPVS = $8,502

NPVL = $16,563 × 3.784 - $50,000

NPVL = $12,674

Create a replacement chain for S.

NPVS* = NPVS + NPVS × .658

NPVS = $8,502 + $8,502 × .658

NPVS = $14,096

Project S should be accepted.

Difficulty: Moderate

Keywords: mutually exclusive, choosing between projects

136. Company K is considering two mutually exclusive projects. The cash flows of the projects are as follows:

Year Project A Project B

0 -$2,000 -$2,000

1 $500

2 $500

3 $500

4 $500

5 $500

6 $500

7 $500 $5,650

a. Compute the NPV and IRR for the above two projects, assuming a 13%

required rate of return.

b. Discuss the ranking conflict.

c. Which of these two projects should be chosen?

a. NPVA = [$500/[(1 + 0.13)t]] - $2,000

= $2,211.30 - $2,000 = $211.3

NPVB = [$5,650/[(1 + 0.13)7]] - $2,000

= $2,401.59 - $2,000 = $401.59

IRR = $2,000 = $500 PVIFA[IRR%, 7 yr.]

Thus, IRRA = 16.3%

$2,000 = $5,650 PVIF[IRR%, 7 yr.]

Thus, IRRB = 15.99%

b. The conflicting rankings are caused by the differing reinvestment assumptions made by the NPV and IRR decision criteria. The NPV criteria assumes that cash flows over the life of the project can be reinvested at the required rate of return or cost of capital, while the IRR criterion implicitly assumes that the cash flows over the life of the project can be reinvested at the internal rate of return.

c. Project B should be taken because it has the largest NPV. The NPV criterion is preferred because it makes the most acceptable assumption for the wealth maximizing firm.

Difficulty: Moderate

Keywords: mutually exclusive, project conflicts