Exam Prep NPV and Investment Decisions Ch6

Principles of Corporate Finance, 13e (Brealey)

Chapter 6 Making Investment Decisions with the Net Present Value Rule

1) The important point(s) to remember while estimating the cash flows of a project

A) is that only cash flow is relevant.

B) are cash flow is relevant and always estimate cash flows on an incremental basis.

C) are to always estimate cash flows on an incremental basis and to be consistent in the treatment of inflation.

D) are cash flow is relevant, always estimate cash flows on an incremental basis, and be consistent in the treatment of inflation.

2) Preferably, a financial analyst estimates cash flows for a project as

A) cash flows before taxes.

B) cash flows after taxes.

C) accounting profits before taxes.

D) accounting profits after taxes.

3) When a firm has the opportunity to add a project that will utilize excess factory capacity (that is currently not being used), which costs should be used to help determine if the added project should be undertaken?

A) Allocated overhead costs

B) Sunk costs

C) Incremental costs

D) Average costs

4) A reduction in the sales of existing products caused by the introduction of a new product is an example of

A) incidental effects.

B) opportunity costs.

C) sunk costs.

D) allocated overhead costs.

5) When Honda develops a new engine, the incidental effects might include the following:

A) demand for replacement parts only.

B) demand for replacement parts and profits from the sale of repair services.

C) demand for replacement parts, profits from the sale of repair services, and offer modified or improved versions of the new engine for other uses.

D) demand for replacement parts and offer modified or improved versions of the new engine for other uses.

6) The cost of a resource that may be relevant to an investment decision even when no cash changes hand is called a(n)

A) sunk cost.

B) opportunity cost.

C) depreciation cost.

D) average cost.

7) Net working capital is best represented as

A) short-term assets only.

B) short-term assets and short-term liabilities.

C) long-term assets and short-term assets.

D) long-term assets and long-term liabilities.

8) Accountants do not depreciate investment in net working capital because

A) it is not a cash flow.

B) it is recovered during or at the end of the project; thus it is not a depreciating asset.

C) it is a sunk cost.

D) working capital appears on the balance sheet, not the income statement.

9) One should consider net working capital (NWC) in project cash flows because

A) typically firms must invest cash in short-term assets to produce finished goods.

B) NWC represents sunk costs.

C) firms need positive NPV projects for investment.

D) inclusion of NWC typically increases calculated NPV.

10) Investment in inventories includes investment in

A) raw material only.

B) raw material and work-in-progress.

C) raw material, work-in-progress, and finished goods.

D) finished goods only.

11) For the case of an electric car project, the following costs should be treated as incremental costs when deciding whether to go ahead with the project except

A) the consequent reduction in sales of the company's existing gasoline models (i.e., incidental effects).

B) interest payments on debt incurred to finance the project.

C) the value of tools that will be transferred to the project from the company's existing plants instead of being sold.

D) the expenditure on new plants and equipment.

12) The principal short-term assets are

A) cash only.

B) cash and accounts payable only.

C) cash, accounts receivable, and inventories.

D) accounts payable only.

13) The current market value of a previously purchased machine proposed for use in a project is an example of a(n)

A) sunk cost.

B) opportunity cost.

C) fixed cost.

D) inventoriable cost.

14) Money that a firm has already spent, or committed to spend regardless of whether a project is taken, is called a(n)

A) fixed cost.

B) opportunity cost.

C) sunk cost.

D) incremental cost.

15) Costs incurred as a result of past irrevocable decisions and irrelevant to future decisions are called

A) opportunity costs.

B) sunk costs.

C) incremental costs.

D) marginal costs.

16) For the case of an electric car project, which of the following costs or cash flows should be categorized as incremental when analyzing whether to invest in the project?

A) The cost of research and development undertaken for developing the electric car during the past three years

B) The annual depreciation charge

C) Tax savings resulting from the depreciation charges

D) Dividend payments

17) An analyst wishes to determine the value of resources used by a proposed project. Which values should the analyst use to approximate opportunity costs?

A) Book values

B) Market values

C) Historical values

D) Accounting values plus an inflation adjustment

18) If the discount rate is stated in nominal terms, then in order to calculate the NPV in a consistent manner, the project requires that

A) cash flows be estimated in nominal terms.

B) cash flows be estimated in real terms.

C) accounting income be used.

D) cash flows be estimated ignoring inflation.

19) If the discount rate is stated in real terms, then in order to calculate the NPV in a consistent manner, the project requires that

A) cash flows be estimated in nominal terms.

B) cash flows be estimated in real terms.

C) accounting income be used.

D) cash flows be estimated including future inflation.

20) A firm owns a building with a book value of $150,000 and a market value of $250,000. If the firm uses the building for a project, then its opportunity cost, ignoring taxes, is

A) $100,000.

B) $150,000.

C) $250,000.

D) $400,000.

21) The real interest rate is 3 percent and the inflation rate is 5 percent. What is the nominal interest rate?

A) 3.00 percent

B) 5.00 percent

C) 8.15 percent

D) 2.00 percent

22) If the nominal interest rate is 7.5 percent and the inflation rate is 4.0 percent, what is the real interest rate?

A) 4.0 percent

B) 9.5 percent

C) 3.4 percent

D) 11.5 percent

23) Your firm expects to receive a cash flow in two years of $10,816 in nominal terms. If the real rate of interest is 2 percent and the inflation rate is 4 percent, what is the real cash flow for year 2?

A) $11,236

B) $10,816

C) $10,000

D) $9,246

24) Given the following data for Project M calculate the NPV of the project.

A) $51.70

B) $35.54

C) $45.21

D) $70.00

25) Given the following data for Project M calculate the NPV of the project.

A) $25.85

B) $17.77

C) $22.65

D) $35.00

26) The real rate of interest is 3 percent and inflation is 4 percent. What is the nominal rate of interest?

A) 3.00 percent

B) 1.00 percent

C) 7.12 percent

D) -1.00 percent

27) The NPV value obtained by discounting nominal cash flows using the nominal discount rate is the same as the NPV value obtained by discounting

A) real cash flows using the real discount rate only.

B) real cash flows using the nominal discount rate only.

C) nominal cash flows using the real discount rate only.

D) real cash flows using the nominal discount rate and nominal cash flows using the real discount rate.

28) The real cash flow occurring in year 2 is $60,000. If the inflation rate is 5 percent per year and the real rate of interest is 2 percent per year, calculate the nominal cash flow for year 2.

A) $60,000

B) $62,424

C) $66,150

D) $63,654

29) Proper treatment of inflation in NPV calculations involves

A) discounting nominal cash flows by the nominal discount rate.

B) discounting real cash flows by the real discount rate.

C) discounting nominal cash flows by the real discount rate.

D) discounting nominal cash flows by the nominal discount rate and discounting real cash flows by the real discount rate.

30) A firm has a general-purpose machine, which has a book value of $300,000 and is worth $500,000 in the market. If the tax rate is 21 percent, what is the opportunity cost of using the machine in a project?

A) $500,000

B) $458,000

C) $300,000

D) $200,000

31) Capital equipment costing $250,000 today has $50,000 salvage value at the end of five years. If the straight-line depreciation method is used, what is the book value of the equipment at the end of two years?

A) $200,000

B) $170,000

C) $140,000

D) $150,000

32) A piece of capital equipment costing $400,000 today has no (zero) salvage value at the end of five years. If straight-line depreciation is used, what is the book value of the equipment at the end of three years?

A) $120,000

B) $80,000

C) $160,000

D) $240,000

33) For project Z, year 5 inventories increase by $6,000; accounts receivable by $4,000; and accounts payable by $3,000. Calculate the increase or decrease in working capital for year 5.

A) Increases by $5,000

B) Decreases by $1,000

C) Increases by $7,000

D) Decreases by $7,000

34) For project A in year 2, inventories increase by $12,000 and accounts payable increase by $2,000. Accounts receivable remain the same. Calculate the increase or decrease in net working capital for year 2.

A) Decreases by $14,000

B) Increases by $14,000

C) Decreases by $10,000

D) Increases by $10,000

35) Working capital is a frequent source of errors in estimating project cash flows. These errors include

A) forgetting about working capital entirely and forgetting that working capital may change during the life of the project.

B) forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting that working capital is recovered at the end of the project.

C) forgetting that working capital may change during the life of the project, forgetting that working capital is recovered at the end of the project, and forgetting to depreciate working capital.

D) forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting to depreciate working capital.

36) If depreciation is $600,000 and the marginal tax rate is 21 percent, then the tax shield due to depreciation is

A) $126,000.

B) $600,000.

C) $390,000.

D) The answer cannot be determined from the information given.

37) If depreciation is $100,000 and the marginal tax rate is 21 percent, then the tax shield due to depreciation is

A) $21,000.

B) $100,000.

C) $65,000.

D) The answer cannot be determined from the information given.

38) Suppose that a project has a depreciable investment of $600,000 and falls under the following MACRS year 5 class depreciation schedule:

year 1: 20 percent; year 2: 32 percent; year 3: 19.2 percent; year 4: 11.5 percent; year 5: 11.5 percent; and year 6: 5.8 percent.

Calculate depreciation for year 2.

A) $120,000

B) $192,000

C) $96,000

D) $115,200

39) Suppose that a project has a depreciable investment of $1,000,000 and falls under the following MACRS year 5 class depreciation schedule:

year 1: 20 percent; year 2: 32 percent; year 3: 19.2 percent; year 4: 11.5 percent; year 5: 11.5 percent; and year 6: 5.8 percent.

Calculate the depreciation tax shield for year 2 using a tax rate of 30 percent.

A) $224,000

B) $60,000

C) $96,000

D) $300,000

40) A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years (i.e., cash flows will occur at t = 1 and t = 2). The corporate tax rate is 21 percent. The assets will depreciate using the MACRS 3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can use all applicable tax shields. The opportunity cost of capital is 12 percent. Assume that the asset can sell for book value at the end of the project. Calculate the NPV of the project (approximately).

A) $22,463

B) $19,315

C) $22,735

D) $5,721

41) A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years (i.e., cash flows will occur at t = 1 and t = 2). The corporate tax rate is 21 percent. The assets will depreciate using the MACRS year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can use all applicable tax shields. The opportunity cost of capital is 11 percent. Assume that the asset can sell for book value at the end of the project. Calculate the approximate IRR for the project.

A) 12.00 percent

B) 11.00 percent

C) 20.02 percent

D) 14.06 percent

42) Your boss asked you to evaluate a project with an infinite life. Sales and costs project to $1,000 and $500 per year, respectively. (Assume sales and costs occur at the end of the year [i.e., profit of $500 at the end of year one]). There is no depreciation and the tax rate is 21 percent. The real required rate of return is 10 percent. The inflation rate is 4 percent and is expected to be 4 percent forever. Sales and costs will increase at the rate of inflation. If the project costs $3,000, what is the NPV?

A) $950.00

B) $1,629.62

C) $365.38

D) $472.22

43) A project requires an investment of $900 today. It can generate sales of $1,100 per year forever. Costs are $600 for the first year and will increase by 20 percent per year. (Assume all sales and costs occur at year-end [i.e., costs are $600 @ t = 1].) The project can be terminated at any time without cost. Ignore taxes and calculate the NPV of the project at a 12 percent discount rate.

A) $65.00

B) $57.51

C) $100.00

D) It cannot be calculated as g > r.

44) Which of the following countries allows firms to keep two separate sets of books, one for the stockholders and one for the tax authorities like the Internal Revenue Service?

A) United States only

B) United States and Japan

C) United States, Japan, and France

D) None of these options are correct.

45) Germany allows firms to choose the depreciation method(s) of

A) straight-line method only.

B) declining-balance method only.

C) straight-line method and declining-balance method.

D) Germany allows a very different system.

46) Two machines, A and B, which perform the same functions, have the following costs and lives.

Which machine would you choose? The two machines are mutually exclusive and the cost of capital is 15 percent.

A) Machine A, because the EAC is $1,789.89

B) Machine B, because the EAC is $1,922.88

C) Machine A, because it has lower PV costs

D) Machine B, because it has longer life

47) Two mutually exclusive projects have the following positive NPVs and project lives.

If the cost of capital were 15 percent, which project would you accept?

A) Project A, because it has higher EAC

B) Project B, because it has higher EAC

C) Project A, because its NPV can be earned more quickly

D) Project B, because it has higher NPV

48) OM Construction Company must choose between two types of cranes. Crane A costs $600,000, will last for five years, and will require $60,000 in maintenance each year. Crane B costs $750,000, will last for seven years, and will require $30,000 in maintenance each year. Maintenance costs for cranes A and B occur at the end of each year. The appropriate discount rate is 12 percent per year. Which machine should OM Construction purchase?

A) Crane A, because EAC is $226,444

B) Crane B, because EAC is $194,33

C) Crane A, because its PV is $816,286 (i.e., less than the PV of Project B)

D) The answer cannot be calculated because the revenues for the project are not given.

49) You are considering the purchase of one of two machines required in your production process. Machine A has a life of two years. Machine A costs $50 initially and then $70 per year in maintenance. Machine B has an initial cost of $90. It requires $40 in maintenance for each year of its three-year life. Either machine must be replaced at the end of its life. Which is the better machine for the firm? The discount rate is 15 percent and the tax rate is zero.

A) Machine A, because EAC for machine A is $100.76

B) Machine B, because EAC for machine B is $79.42

C) Machine A, because PV of costs for machine A is $163.80

D) Machine B, because PV of costs for machine B is $181.33

50) RainMan Inc. is in the business of producing rain upon request. They must decide between two investment projects: a new airplane for seeding rain clouds or a new weather control machine built by Dr. Nutzbaum. The discount rate for the new airplane is 9 percent, while the discount rate for the weather machine is 39 percent (it happens to have higher market risk). Which investment should the company select and why? (Assume a 0 percent inflation rate and that projected costs do not change over time.)

A) Airplane, because it has a higher NPV

B) Weather machine, because it has a higher NPV

C) Airplane, because it has a higher equivalent annual cash flow

D) Weather machine, because it has a higher equivalent annual cash flow

51) Using the technique of equivalent annual cash flows and a discount rate of 7 percent, what is the value of the following project?

A) 3.06

B) 3.61

C) 10.25

D) 12.23

52) When calculating cash flows, one should consider them on an incremental basis.

53) When calculating cash flows, one should consider all incidental effects.

54) Opportunity costs should not be included in project analysis, as they are missed opportunities.

55) Working capital is needed for additional investment within a project and should be included within cash-flow estimates.

56) Sunk costs are bygones (i.e., they are unaffected by the decision to accept or reject a project). They should therefore be ignored.

57) By undertaking an analysis in real terms, the financial manager avoids having to forecast inflation.

58) A financial analyst should include interest and dividend payments when calculating a project's cash flows.

59) Depreciation expense acts as a tax shield in reducing taxes.

60) Working capital is one of the most common sources of mistakes in estimating project cash flows.

61) Within the MACRS system of depreciation, most industrial equipment falls into the 10-15 year classes.

62) Most large U.S. corporations keep two separate sets of books, one for stockholders and one for the Internal Revenue Service.

63) A financial analyst can use the equivalent annual cash-flow approach to determine the year in which an existing machine can be profitably replaced with a new machine.

64) The rule for comparing machines with different lives is to select the machine with the greatest equivalent annual cost (EAC).

65) You should replace a machine when the EAC of continuing to operate it exceeds the EAC of the new machine.

66) When evaluating mutually exclusive projects with positive NPV but different life spans, the proper technique to employ is the equivalent annual cash-flow approach.

67) The equivalent annual cash-flow technique is primarily used whenever the lives of two different projects are the same.

68) Define the term cash flow for a project.

69) What are some of the important points to remember while estimating the cash flows of a project?

70) Briefly explain how inflation is treated consistently while estimating a project's NPV.

71) Briefly explain the acronym MACRS.

72) Briefly discuss how tax reporting to governments versus shareholders is treated in countries like Japan.

73) What are some of the additional factors that an analyst should consider while estimating cash flows in foreign countries and currencies?

74) How do you compare projects with different lives?

75) Briefly explain how the decision to replace an existing machine is made.

76) Briefly explain how the cost of excess capacity is taken into consideration.