Chapter 9 Capital Budgeting
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Questions and Answers

Sale of an asset for less than book value creates an operating loss which effectively reduces the company's taxes by an amount equal to ____ times the loss.

  • the loss, one minus the company's marginal tax rate
  • the loss, the company's marginal tax rate (correct)
  • one-half the loss, the company's marginal tax rate
  • one-half the loss, one minus the company's marginal tax rate

The value of resources used in an investment project should be measured in terms of their ____.

  • depreciated cost
  • opportunity cost (correct)
  • acquisition cost
  • historical cost

There is neither a gain or a loss on the sale of a depreciable asset for an amount exactly equal to its ____.

  • opportunity cost
  • historical cost
  • acquisition cost
  • tax book value (correct)

The ____ is a schedule of projects arranged in order according to their expected rates of return.

<p>investment opportunity curve, descending (C)</p> Signup and view all the answers

Which of the following would not be classified as a capital expenditure for decision-making purposes?

<p>purchase of 90-day Treasury Bills (B)</p> Signup and view all the answers

A firm's cost of capital is:

<p>an important input in the capital budgeting process (B)</p> Signup and view all the answers

The decision by the Municipal Transportation Authority to either refurbish existing buses, to buy new large buses, or to supplement the existing fleet with mini-buses is an example of:

<p>mutually exclusive projects (C)</p> Signup and view all the answers

Which of the following is not a major difficulty in implementing the basic capital budgeting model?

<p>choosing an appropriate criterion for selecting among various investment alternatives (C)</p> Signup and view all the answers

Which of the following is not a major step in the capital budgeting process?

<p>analyzing the effect of a project on the firm's financial ratios (A)</p> Signup and view all the answers

Which of the following is a basic principle when estimating a project's cash flows?

<p>cash flows should be measured on an incremental basis (C)</p> Signup and view all the answers

Which of the following items is not considered as a part of the net investment calculation?

<p>the first year's net cash flow (C)</p> Signup and view all the answers

The effect of a one dollar increase in depreciation expenses is to ____ the typical firm's net cash flows by ____ one dollar.

<p>increase, less than (C)</p> Signup and view all the answers

The dollar amount of interest charges is:

<p>normally not considered in the net cash flow calculation (C)</p> Signup and view all the answers

Raider Productions has to decide whether to build its warehouse in Dallas or Houston. This decision falls into the class of:

<p>mutually exclusive projects (D)</p> Signup and view all the answers

The determination of net cash flows (NCF) should never include:

<p>interest charges (B)</p> Signup and view all the answers

In estimating the net investment, an outlay that has already been made is known as a (n) ____.

<p>sunk cost (A)</p> Signup and view all the answers

Which of the following are (is) generally considered problems associated with cash flow estimation?

<p>uncertainty about the future cash flows and the introduction of bias into the estimation of cash flows (D)</p> Signup and view all the answers

Most firms choose accelerated depreciation methods because

<p>income taxes are deferred (D)</p> Signup and view all the answers

Cash flows for all investment projects should be projected over the____ of the project

<p>economic life (C)</p> Signup and view all the answers

When a firm sells an asset for_____ , it realizes a capital gain and must pay income taxes on it.

<p>more than its original cost (D)</p> Signup and view all the answers

In estimating the net investment, an outlay that has already been made is known as a_____

<p>sunk cost (A)</p> Signup and view all the answers

Depreciation is based on the asset cost plus all of the following except

<p>increase in inventory (B)</p> Signup and view all the answers

Depreciation____ reported profits and it____ taxes paid by a firm.

<p>reduces, reduces (B)</p> Signup and view all the answers

If a firm sells an asset for less than its book value,

<p>the loss may be used to offset operating income (D)</p> Signup and view all the answers

The_____ the amount of depreciation charged in a period, the____ will be the firm’s taxable income.

<p>greater, lower (A)</p> Signup and view all the answers

In terms of the capital budgeting process, net cash flows are

<p>incremental changes in a firm’s cash flow. (C)</p> Signup and view all the answers

A recent survey of Fortune 500 firms regarding their cash flow estimation procedures indicated that

<p>the majority produced detailed cash flow projections (B)</p> Signup and view all the answers

Depreciation

<p>is not a cash outflow. (C)</p> Signup and view all the answers

The capital budgeting process is very important to the firm because it:

<p>essentially plots the company’s future direction (B)</p> Signup and view all the answers

A____ is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than 1 year.

<p>capital expenditure (C)</p> Signup and view all the answers

The set of investment projects arranged in descending order according to their expected rates of return is known as the ____.

<p>simplified capital budgeting model (A)</p> Signup and view all the answers

A____project is one whose acceptance is dependent on the adoption of one or more other projects.

<p>contingent (A)</p> Signup and view all the answers

The net cash flows for any year during the life of capital expenditure project are equal to the change in plus the change in _____.

<p>earnings after taxes; depreciation (C)</p> Signup and view all the answers

The net investment calculation for an____project normally includes____.

<p>asset replacement; after-tax proceeds from the sale of the old asset (A)</p> Signup and view all the answers

There is a capital gain on the sale of an asset for ____.

<p>more than its original cost (B)</p> Signup and view all the answers

The net investment calculation for an asset replacement decision normally includes any___ .

<p>after-tax salvage value of the old asset and increase in net working capital (C)</p> Signup and view all the answers

When calculating the net cash flow in a project’s expected final year,

<p>the after-tax salvage value of any project equipment is considered (B)</p> Signup and view all the answers

When managers knowingly bias estimates of cash flows from investment projects in order to serve their personal objectives, they are____.

<p>departing from the shareholder wealth maximization goal (C)</p> Signup and view all the answers

Capital expenditure projects may be classified in all the following types except:

<p>capital rationing (D)</p> Signup and view all the answers

_____have cash flow patterns with more than one sign change.

<p>non-normal projects (B)</p> Signup and view all the answers

The difference between a capital expenditure and an operating expenditure is that a capital expenditure:

<p>is expected to generate future cash benefits lasting longer than one year. (C)</p> Signup and view all the answers

Of the following, an example of a component of a firm’s cost of capital is:

<p>The return on common stock required by investors. (D)</p> Signup and view all the answers

A contractor has a team of plumbers and assigns those plumbers to a new construction site. The fact that the plumbers are unavailable for any other job makes the construction site project a/an:

<p>contingent project (D)</p> Signup and view all the answers

A term meaning that the firm has limited funds and must choose only those projects that will be profitable is

<p>capital rationing (C)</p> Signup and view all the answers

Flashcards

Net Investment (NINV)

The amount of money a company has to invest in a project, including the initial cost, installation, and any changes to working capital.

Capital Expenditure

Cash outlays expected to generate future cash benefits lasting longer than one year.

Marginal Cost of Capital (MCC)

The cost of successive increments of capital acquired by a company. It increases as more funds are needed, because investors demand higher returns for taking on more risk.

Investment Opportunity Schedule

A schedule of projects arranged in descending order according to their expected rates of return.

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Sunk Cost

An expenditure that has already been made and cannot be recovered. It should not be considered in decision-making.

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Opportunity Cost

The value of a resource in its best alternative use. Consider what a resource could earn if it were used in the next best project.

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Incremental Cash Flows

When accepting or rejecting a project, only consider the future changes in cash flows caused by the project. Ignore costs that are not directly affected by the decision.

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Earnings before Interest and Taxes (EBIT)

The difference between revenues and expenses (excluding depreciation) for a company. It is NOT the same as cash flows.

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Earnings before Taxes (EBT)

The total income earned before subtracting taxes. It is NOT the same as cash flows.

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Income Statement

The financial statement that summarizes the company's revenues, expenses, and profits for a specific time period. It is NOT the same as cash flows.

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Depreciation

A non-cash expense that reflects the gradual wear and tear of an asset over its useful life. It is used to lower taxes.

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Marginal Tax Rate

The tax rate a company pays on each additional dollar of income. It is used to calculate the after-tax cash flows.

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Book Value

The value of an asset as recorded on the company's balance sheet. It is NOT the same as market value.

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Salvage Value

The amount of money a company receives from selling an asset. It can be higher or lower than the book value.

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Capital Gain/Loss

A gain or loss a company realizes on the sale of an asset when the selling price differs from the book value.

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Depreciation Method

The method used to calculate depreciation expenses over time. There are different methods (straight-line, MACRS) that affect the timing of tax savings.

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Independent Projects

Projects that are independent of each other - the decision to accept one does not affect the decision on others.

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Mutually Exclusive Projects

Projects where accepting one prevents the acceptance of the other. Choose the project with the highest return.

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Contingent Projects

Projects where the acceptance of one project depends on the acceptance of another. The decision to accept the first project is a prerequisite for the second.

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Non-conventional Project

A project that has more than one change in the sign of its cash flows – it may have initial outflows, then inflows, then more outflows, etc.

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Conventional Project (Normal Project)

These projects have one sign change in their cash flows – typically an initial outflow followed by inflows.

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Post-Audit

A process used by companies to compare their actual performance to planned performance for capital projects. Helps identify problems and ensure the project stays on track.

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Capital Rationing

A situation where a company has limited funds and needs to select the most profitable projects from a pool of potential investments.

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Earnings After Taxes (EAT)

The net income (profit) earned from a project after subtracting depreciation but before paying for any debt (interest). It is NOT the same as cash flow.

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Discounted Cash Flow (DCF)

A technique used in capital budgeting to account for the time value of money – a dollar today is worth more than a dollar in the future.

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Accelerated Depreciation

A method of depreciation that allows for larger depreciation expense in the early years of an asset's life, leading to lower taxes in those years.

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Incremental Cash Flows

The extra amount of revenue or reduced costs that a project is expected to create. It is the basis for calculating cash flows

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Capital Budgeting

The process of analyzing and choosing capital projects to invest in, considering their profitability and alignment with the company's strategic goals.

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Cost of Capital

A firm's cost of capital is an important input in the capital budgeting process.

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Tax Consequences

A gain or loss on the sale of an asset results in tax consequences.

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Study Notes

Capital Budgeting and Cash Flow Analysis

  • Sale of an asset below book value: Creates an operating loss, reducing company taxes by ½ the loss multiplied by one minus the marginal tax rate.
  • Resource valuation in investment projects: Measured by opportunity cost, not historical cost or acquisition cost.
  • Depreciable asset sale with exact book value: Results in neither a gain nor a loss.
  • Investment opportunity curve: A schedule of projects ordered by their expected rates of return. It is a descending curve.
  • Capital expenditure vs. operating expenditure: Capital expenditures are for long-term assets, while operating expenses are for day-to-day operations. For example, buying a building is a capital expenditure, while paying rent is an operating expense. A training program is a capital expenditure, and buying Treasury bills is an operating expenditure.

Additional Analysis Items

  • Cost of Capital: A critical financial ratio used in the capital budgeting process.
  • Independent vs. Mutually Exclusive Projects: Decisions about independent projects do not affect the choice of others; mutually exclusive projects, on the other hand, must be considered as alternatives.
  • Capital Budgeting Process Steps: Generating proposals, estimating cash flows, analyzing alternatives, and post-audit.
  • Net Investment Calculation: Excludes the first year's net cash flow, and includes increases in net working capital, salvage value, or installation & shipping charges.
  • Depreciation Effect on Cash Flows: One dollar increase in depreciation reduces net cash flows by one dollar, but is a non-cash flow item.
  • Interest Charges in Net Cash Flow Estimation: Interest charges are normally not included in the net cash flow calculation.
  • Alternative Investment Decisions: A firm faces a choice between different investment projects if the projects are mutually exclusive and the firm lacks the resources to undertake every profitable project.
  • Net Investment Calculation Details: For asset replacement decisions, it normally includes the after-tax salvage value of the old asset. If cash flows from the old asset can be increased, then the after-tax salvage value of the old asset and any increase in working capital are considered.
  • Net Cash Flow Calculation: Net cash flow is the difference between a project's cash inflows and cash outflows during a specific period. Cash inflows are the project's revenues, while cash outflows are the expenses associated with the project.
  • Sunk Costs: Already incurred costs that should not be considered when evaluating a project.
  • Capital Rationing: A constraint on the funds available for capital budgeting, forcing firms to prioritize projects.
  • Contingent Projects: A project that is contingent on the adoption of one or more other projects.
  • Mutually Exclusive Projects: Projects in which selecting one prevents the selection of another.
  • Non-conventional Projects: Projects with multiple sign changes in their cash flow stream.
  • Conventional Projects: Projects with a single sign change in their cash flow stream.

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Chapter 9: Capital Budgeting and Cash Flow Analysis PDF

Description

Test your understanding of capital budgeting concepts and cash flow analysis with this quiz. Explore key items like sale of assets, resource valuation, and the difference between capital and operating expenditures. Assess your knowledge on the implications of financial decisions on taxes and investment opportunities.

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