Chapter 9: Capital Budgeting and Cash Flow Analysis PDF

CHAPTER 9: CAPITAL BUDGETING AND CASH FLOW ANALYSIS 1. 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. a. one-half the loss, the company’s marginal tax rate b. the loss, one minu...

CHAPTER 9: CAPITAL BUDGETING AND CASH FLOW ANALYSIS 1. 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. a. one-half the loss, the company’s marginal tax rate b. the loss, one minus the company’s marginal tax rate c. one-half the loss, one minus the company’s marginal tax rate d. the loss, the company’s marginal tax rate ANSWER: d 2. The value of resources used in an investment project should be measured in terms of their a. acquisition cost b. historical cost c. opportunity cost d. depreciated cost ANSWER: c 3. There is neither a gain or a loss on the sale of a depreciable asset for an amount exactly equal to its. a. acquisition cost b. tax book value c. opportunity cost d. historical cost ANSWER: b 4. The is a schedule of projects arranged in order according to their expected rates of return. a. investment opportunity curve, ascending b. marginal cost of capital curve, ascending c. investment opportunity curve, descending d. marginal cost of capital curve, descending ANSWER: c 5. Which of the following would not be classified as a capital expenditure for decision-making purposes? a. purchase of a building b. investment in a management training program c. purchase of 90-day Treasury Bills d. development of a major advertising campaign ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 6. A firm’s cost of capital is: a. an important financial ratio b. equal to 10 percent c. rarely used in practice d. an important input in the capital budgeting process ANSWER: d 7. 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: a. independent projects b. mutually exclusive projects c. contingent projects d. separable projects ANSWER: b 8. Which of the following is not a major difficulty in implementing the basic capital budgeting model? a. determining the schedule of available projects before a decision on any one project can be made b. accounting for the risk of individual projects. c. projecting the cost of funds over the investment decision horizon d. choosing an appropriate criterion for selecting among various investment alternatives ANSWER: d 9. Which of the following is not a major step in the capital budgeting process? a. generating investment project proposals b. estimating cash flows c. analyzing the effect of a project on the firm’s financial ratios d. performing a project post-audit and review ANSWER: c 10. Which of the following is a basic principle when estimating a project’s cash flows? a. cash flows should be measured on a pretax basis b. cash flows should ignore depreciation because it is a non-cash charge c. only direct effects of a project should be included in cash flow calculations d. cash flows should be measured on an incremental basis ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 11. Which of the following items is not considered as a part of the net investment calculation? a. the first year’s net cash flow b. increase in net working capital c. salvage of an old piece of equipment that is being replaced d. installation and shipping charges ANSWER: a 12. The effect of a one dollar increase in depreciation expenses is to the typical firm’s net cash flows by one dollar. a. increase, less than b. increase, exactly c. decrease, more than d. increase, more than ANSWER: a 13. The dollar amount of interest charges is: a. always considered in the net cash flow calculation b. normally not considered in the net cash flow calculation c. always considered as a part of the net investment d. never a consideration ANSWER: b 14. Raider Productions has to decide whether to build its warehouse in Dallas or Houston. This decision falls into the class of: a. independent projects b. mutually exclusive projects c. contingent projects d. marginal projects ANSWER: b 15. The determination of net cash flows (NCF) should never include a. changes in depreciation b. changes in operating costs c. interest charges d. indirect effects ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 16. Which of the following are (is) generally considered problems associated with cash flow estimation? a. uncertainty about the future cash flows b. the introduction of bias into the estimation of cash flows c. uncertainty about the magnitude of fixed cost financing charges d. uncertainty about the future cash flows and the introduction of bias into the estimation of cash flows ANSWER: d 17. Most firms choose accelerated depreciation methods because a. reported net income is higher b. tax payments are made sooner, resulting in a lower deferred tax liability c. operating expenses are correspondingly reduced d. income taxes are deferred ANSWER: d 18. Cash flows for all investment projects should be projected over the of the project. a. MACRS recovery period b. depreciable life c. economic life d. smaller of depreciable or economic lives ANSWER: c 19. When a firm sells an asset for , it realizes a capital gain and must pay income taxes on it. a. book value b. less than book value c. more than book value but less than original cost d. more than its original cost ANSWER: d 20. is the term used when the initial cost of all acceptable capital budgeting projects is greater than the total funds the firm has available. a. Profit maximization b. Funds constraint c. Mutually exclusive d. Contingent ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 21. In estimating the net investment, an outlay that has already been made is known as a (n). a. sunk cost b. cash outflow c. opportunity cost d. expansion cost ANSWER: a 22. Depreciation is based on the asset cost plus all of the following except a. shipping costs b. increase in inventory c. installation d. cost of attached equipment acquired at the same time ANSWER: b 23. Depreciation reported profits and it taxes paid by a firm. a. increases, reduces b. reduces, reduces c. reduces, increases d. increases, increases ANSWER: b 24. If a firm sells an asset for less than its book value, a. there are no tax consequences b. the loss is treated as lost depreciation c. the loss reduces depreciation expenses d. the loss may be used to offset operating income ANSWER: d 25. The the amount of depreciation charged in a period, the will be the firm’s taxable income. a. greater, lower b. lower, lower c. lower, greater d. greater, higher ANSWER: a 26. In terms of the capital budgeting process, net cash flows are a. the net cash outlays required to place a project in service. b. the funds invested in additional assets. c. incremental changes in a firm’s cash flow. d. the outlays that have already been made. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis ANSWER: c 27. A recent survey of Fortune 500 firms regarding their cash flow estimation procedures indicated that a. few firms prepared formal cash flow estimates b. the majority produced detailed cash flow projections c. a majority estimated cash flows for a range of estimates d. about 50 percent made comparisons between actual and projected cash flows. ANSWER: b 28. Depreciation a. does not affect cash flows. b. does not affect profits. c. is not a cash outflow. d. is a cash inflow. ANSWER: c 29. The capital budgeting process is very important to the firm because it: a. highlights the impacts of a project on net income b. essentially plots the company’s future direction c. is used in working capital analysis d. indicates the net cash flows available for employee education ANSWER: b 30. A (n) is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than 1 year. a. depreciation charge b. operating expenditure c. capital expenditure d. capital gain ANSWER: c 31. The set of investment projects arranged in descending order according to their expected rates of return is known as the ____. a. marginal cost of capital schedule b. schedule of mutually exclusive projects c. schedule of contingent projects d. simplified capital budgeting model ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 32. A(n) project is one whose acceptance is dependent on the adoption of one or more other projects. a. contingent b. mutually exclusive c. independent d. perfectly correlated ANSWER: a 33. The net cash flows for any year during the life of capital expenditure project are equal to the change in plus the change in. a. earnings before interest and taxes; depreciation b. earnings before taxes; depreciation c. earnings after taxes; depreciation d. revenues; costs ANSWER: c 34. The net investment calculation for an project normally includes. a. asset expansion; pretax proceeds from the sale of the old asset b. asset replacement; pretax proceeds from the sale of the old asset c. asset expansion; after-tax proceeds from the sale of the old asset d. asset replacement; after-tax proceeds from the sale of the old asset ANSWER: d 35. There is a capital gain on the sale of an asset for. a. more than its original cost b. more than its book value but less than its original cost c. its depreciation value d. its net present value ANSWER: a 36. The net investment calculation for an asset replacement decision normally includes any. a. after-tax salvage value of the old asset b. increase in net working capital c. after-tax salvage value of the old asset and increase in net working capital d. cannot be computed ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 37. When calculating the net cash flow in a project’s expected final year, a. recovery of any working capital invested is disregarded b. the after-tax salvage value of any project equipment is considered c. the remaining principal on any borrowed funds is considered d. the sales proceeds from any land associated with the project is disregarded ANSWER: b 38. When managers knowingly bias estimates of cash flows from investment projects in order to serve their personal objectives, they are. a. performing management by exception b. increasing their total compensation c. departing from the shareholder wealth maximization goal d. increasing their confidence level ANSWER: c 39. Capital expenditure projects may be classified in all the following types except: a. growth opportunities b. required to meet legal requirements c. cost reduction opportunities d. capital rationing ANSWER: d 40. have cash flow patterns with more than one sign change. a. conventional projects b. non-normal projects c. normal projects d. contingent projects ANSWER: b 41. A drill press costs $30,000 and is expected to have a 10 year life. The drill press will be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. This machine is expected to reduce the firm’s cash operating costs by $4,500 per year. If the firm is in the 40 percent marginal tax bracket, determine the annual net cash flows generated by the drill press. a. $4,500 b. $900 c. $5,700 d. $3,900 ANSWER: d RATIONALE: Solution: NCF = ($0 – (–$4,500) – $3,000)(1 – 0.40) + $3,000 = $3,900 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 42. An investment project is expected to generate earnings before taxes (EBT) of $60,000 per year. Annual depreciation from the project is $30,000 and the firm’s tax rate is 40 percent. Determine the project’s annual net cash flows. a. $48,000 b. $66,000 c. $36,000 d. $52,000 ANSWER: b RATIONALE: Solution: NCF = $60,000(1 – 0.40) + $30,000 = $66,000 43. Ten years ago J-Bar Company purchased a lathe for $250,000. It was being depreciated on a straight-line basis to an estimated $25,000 salvage value over a 15 year period. The firm is considering selling the old lathe and purchasing a new one. The new lathe would cost $500,000. The firm’s marginal tax rate 40 percent. Determine the net investment required to purchase the new lathe, if the old lathe is sold for $100,000. a. $380,000 b. $397,500 c. $400,000 d. $418,000 ANSWER: c RATIONALE: Solution: New lathe cost $500,000 Less: Salvage value (old lathe) –100,000* Net investment $400,000 *Book value (old lathe) = $250,000 – 10[($250,000 – $25,000)/15] = $100,000. Because book value equals salvage value, no gain or loss is incurred on sale of old lathe. 44. Little Giant is building a manufacturing plant that will require a cash outlay of $300,000 for the initial purchase of a building, $450,000 for remodeling the first year, and $710,00 for new equipment in the second year. If the firm’s cost of capital is 12 percent, what is the present value of the net investment at time 0? a. $1,460,000 b. $1,132,070 c. $1,267,720 d. $300,000 ANSWER: c RATIONALE: Solution: PV of NINV = $300,000 + $450,000(0.893) + $710,000(0.797) = $1,267,720 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 45. In Step Video is considering expanding its video rental library to 8,000 tapes. The purchase price of the additional videos will be $80,000 and the shipping cost is another $4,000. To house the tapes, the owner will have to spend another $10,000 for display shelves, increase net working capital by $5,000, and interest expenses will add another $8,000 to the operating cost. What is the net investment to In Step Video for this project? a. $95,000 b. $99,000 c. $84,000 d. $107,000 ANSWER: b RATIONALE: Solution: NINV = $80,000 + $4,000 + $10,000 + $5,000 = $99,000 46. What is the net investment for an extruder that costs $42,000, if shipping costs are $1,500 and installation is $4,800? Assume this efficient machine is replacing an older extruder with a book and market value of zero. The replacement investment will reduce operating costs by $6,600 a year. a. $48,300 b. $54,900 c. $43,500 d. $51,000 ANSWER: a RATIONALE: Solution: NINV = $42,000 + $1,500 + $4,800 = $48,300 47. Shunt Technology will spend $800,000 on a piece of equipment that will manufacture fine wire for the electronics industries. The shipping and installation charges will be $240,000 and net working capital will increase $48,000.The equipment will replace an existing machine that has a salvage value of $75,000 and a book value of $125,000. If Shunt has a current marginal tax rate of 34 percent, what is the net investment? a. $1,030,000 b. $1,163,000 c. $1,033,000 d. $996,000 ANSWER: d RATIONALE: Solution: NINV = $800,000 + $240,000 + $48,000 - $75,000 – $17,000* = $996,000 *($125,000 – $75,000)(0.34) = $17,000 tax saving on loss 48. Capital Foods purchased an oven 5 years ago for $45,000. The oven is being depreciated over its estimated 10-year life using the straight line method to a salvage value of $5,000. Capital is planning to replace the oven with a more automated one that will cost $150,000 installed. If the old oven can be sold for $30,000, what is the tax liability? Assume a marginal tax rate of 40 percent. a. $900 b. $2,000 c. $127,000 d. $25,000 ANSWER: b RATIONALE: Solution: Book Value = $45,000 – 5($45,000 – $5,000)/10 = $25,000 Tax liability = ($30,000 – $25,000)(0.4) = $2,000 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 49. The management of Jasper Equipment Company is planning to purchase a new milling machine that will cost $160,000 installed. The old milling machine has been fully depreciated but can be sold for $15,000. The new machine will be depreciated on a straight line basis over its 10 year economic life to an estimated salvage value of $10,000. If this milling machine will save Jasper $20,000 a year in production expenses, what are the annual net cash flows associated with the purchase of this machine? Assume a marginal tax rate of 40 percent. a. $15,000 b. $18,000 c. $27,000 d. $21,000 ANSWER: b RATIONALE: Solution: Depreciation/yr. = ($160,000 – $10,000)/10 = $15,000 NCF = ($20,000 – $15,000)(1 – 0.4) + $15,000 = $18,000 50. Jim Bo’s currently has annual cash revenues of $240,000 and annual operating expenses of $185,000 including $35,000 in depreciation. The firm’s marginal tax rate is 40 percent. A new cutting machine can be purchased for $120,000 will increase revenues by $50,000 per year while operating expenses would increase to $205,000, including $42,000 in depreciation. Compute Jim Bo’s annual incremental after-tax net cash flows. a. $25,000 b. $20,800 c. $93,000 d. $19,000 ANSWER: a RATIONALE: Solution: NCF = ($50,000 – $20,000)(1 – 0.4) + $7,000 = $25,000 51. Moon Pie Company is considering automated baking equipment that costs $500,000 installed and would replace the present hand-made production method. The present equipment has a zero book and salvage value. The new equipment will not increase revenues but will reduce operating costs from a current level of $600,000 to $300,000 per year. The depreciation of the new equipment will be $73,000 per year. What are the annual incremental net cash flows? Assume a marginal tax rate of 40 percent. a. $296,800 b. $136,200 c. $192,200 d. $209,200 ANSWER: d RATIONALE: Solution: NCF = ($300,000 – $73,000)(1 – 0.4) + $73,000 = $209,200 52. LISP Inc. is planning to purchase a new mixer/dubber for $50,000. The new equipment will replace an older mixer that has been fully depreciated but has a salvage value of $5,000. Compute the net investment required for this project. Assume a marginal tax rate of 40 percent. a. $47,000 b. $45,000 c. $48,000 d. $55,000 ANSWER: a RATIONALE: Solution: NINV = $50,000 – $5,000 + $5,000(0.4) = $47,000 53. LISP Inc. is planning to purchase a new mixer for $50,000 that will qualify as MACRS 3-year property (first © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis year depreciation rate = 33.33%). The new mixer should increase revenues by $20,000 per year with no increase in operating cost. If LISP’s marginal tax rate is 40 percent, what is the net cash flow in the first year? a. $22,665 b. $19,000 c. $18,666 d. $21,500 ANSWER: c RATIONALE: Solution: Dep. = $50,000(.333) = $16,665 NCF = ($20,000 – $16,665)(1 – 0.4) + 16,665 = $18,666 54. Outback is purchasing a new machine that will cost $98,000. The machine will qualify as MACRS 5-year property but has an economic life of 8 years. The new machine is expected to increase revenues by $35,000 per year and operating costs are expected to increase by $15,000 per year. If the firm’s marginal tax rate is 34 percent and the first year’s depreciation rate is 20 percent, what is the net cash flow in the first year. a. $264 b. $7,984 c. $19,864 d. $26,034 ANSWER: c RATIONALE: Solution: NCF = ($35,000 – $15,000 – $19,600)(1 – 0.34) + $19,600 = $19, 864 55. What is the net investment required for a pitting machine that will cost $35,000 including installation? The machine replaces a machine that cost $5,000 when purchased five years ago. The old machine has been fully depreciated but has a market value of $6,000. Assume the marginal tax rate is 40 percent. a. $29,000 b. $31,400 c. $32,600 d. $34,505 ANSWER: b RATIONALE: Solution: NINV = $35,000 – $6,000 + $6,000(0.4) = $31,400 56. Allen Company is considering an investment project that is expected to generate $100,000 in annual earnings before taxes. Annual depreciation will be $50,000. Allen’s marginal tax rate is 40%. Determine the project’s annual net cash flows. a. $150,000 b. $110,000 c. $90,000 d. $60,000 ANSWER: b RATIONALE: Solution: NCF = ΔEBT(1 - T) + ΔDep = $100,000(1 – 0.40) + $50,000 = $110,000 57. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 57. Baker Company is considering an investment in a new metal lathe. If the new lathe is purchased, revenues will increase by $5,000 per year and cash operating costs will decline by $10,000 per year. The lathe will cost $60,000 and will be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. Baker’s marginal tax rate is 40%. Determine the annual net cash flows generated by the lathe. a. $11,400 b. $9,000 c. $600 d. $5,400 ANSWER: a RATIONALE: Solution: NCF = (ΔR – Δ0 – ΔDep)(1 – T) + ΔDep = [$5,000 – (–$10,000) – $6,000](1 – 0.40) + $6,000 = $11,400 58. Basin Manufacturing (40% marginal tax rate) is considering a plant expansion project. The equipment will cost $100,000 and will require an additional $10,000 for delivery and installation. The expansion also will require Basin to increase immediately its net working capital by $25,000. The expansion is expected to generate revenues of $150,000 per year. Calculate the project’s net investment. a. $81,000 b. $125,000 c. $131,000 d. $135,000 ANSWER: d RATIONALE: Solution: NINV = $100,000 + $10,000 + $25,000 = $135,000 59. Maritech purchased a pellet mill 4 years ago for $60,000. The mill is being depreciated over 7 years using MACRS. Maritech is planning to replace the mill with a higher volume unit that will cost $110,000 installed. If the old mill can be sold for $25,000, what is the tax liability? Assume a marginal tax rate of 40%. Use the rounded MACRS schedule listed below. (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $3,754 b. $7,498 c. $2,560 d. $16,502 ANSWER: c RATIONALE: Solution: Book value = $60,000 ×.31 = $18,600 OR 60,000 – (60,000 ×.69) = 18,600 Tax liability = (25,000 – 18,600)(.4) = $2,560 60. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 60. Rupp Pumps is purchasing an extruder for $80,000. The extruder will require an expenditure of $12,000 for installation and $4,000 for training new operators. The new equipment will require an increase of $5,000 in inventory, $4,000 in accounts receivable, and $3,000 in accounts payable. What is the net investment for this project? a. $108,000 b. $102,000 c. $98,000 d. $99,000 ANSWER: b RATIONALE: Solution: NINV = $80,000 + $12,000 + $4,000 + (5,000 + 4,000 - 3,000) = $102,000 61. Airstat is replacing an old stamping line that cost $80,000 five years ago, with a new, more efficient machine that will cost $225,000. Shipping and installation will cost an additional $20,000. The old machine has a book value of $15,000 but will be sold as scrap for $5,000. The new machine will be depreciated with a 7 year life under MACRS guidelines. With the increased production, inventories will increase $4,000, accounts receivable will increase $16,000, and accounts payable will increase $14,000. If Airstat has a marginal tax rate of 40 percent, what is the net investment? a. $274,000 b. $242,000 c. $260,000 d. $274,000 ANSWER: b RATIONALE: Solution: NINV = $225,000 + $20,000 – $5,000 – $10,000(0.4) + $4,000 + $16,000 – $14,000 = $242,000 62. Ripstart is replacing an old, fully depreciated stamping line with a more efficient machine that will cost $245,000. The line will be depreciated as a 7-year MACRS asset. With the increased production, Ripstart expects revenues to increase by $55,000, and operating expenses to increase by $20,000. If Ripstart expects to sell the new machine at the end of year 5 for $40,000, compute the net cash flow in the fifth year. The MACRS depreciation rate during the fifth year is 8.93% and the accumulated MACRS depreciation after five years totals 77.69 percent of the cost of the asset. Assume the firm’s marginal tax rate is 40 percent and that company does get to take the full benefit of year 5 depreciation. a. $29,751 b. $53,736 c. $75,615 d. $69,751 ANSWER: c RATIONALE: Solution: Dep5 = 245,000(0.0893) = 21,878.50 Book value at the end of year 5 = $245,000 - $245,000(0.7769) = $54,659.50 NCF5 = ($55,000 – $20,000 – $21,878.50)(1 – 0.4) + $21,878.50 + $40,000 + ($54,659.50 – $40,000)0.4 = $7,872.90 + $61,878.50 + $5,863.80 = $75,615.20 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 63. Felix Industries purchased a grinder 5 years ago for $15,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It could be sold now for $6,000. The firm is considering selling it and purchasing a new one. The new grinder would cost $25,000 installed and would be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. The company’s marginal tax rate is 40%. Determine the net investment if the old grinder is sold and the new one purchased. a. $19,000 b. $16,600 c. $17,400 b. cannot be computed ANSWER: c RATIONALE: Solution: Cost of grinder (installed) $25,000 Proceeds from sale of old grinder – 6,000 Net investment before taxes $19,000 Tax saving on loss ($10,000 – $6,000 = $4,000) from sale of old grinder ($4,000 × 0.40) – 1,600 Net investment (NINV) $17,400 64. Consider a capital expenditure project with an expected 10-year economic life and forecasted revenues equal to $40,000 per year; cash expenses are estimated to be $29,000 per year. The cost of the project equipment is $23,000, and the equipment’s estimated salvage value at the end of the project is $9000.The equipment’s $23,000 cost will be depreciated using MACRS depreciation (7-year asset). The project requires a $7,000 working capital investment in year 0 and another $5,000 in year 5. The company’s marginal tax rate is 40%. Calculate the expected net cash flow in year 10 of the project. a. $32,000 b. $27,000 c. $24,000 d. $18,000 ANSWER: c RATIONALE: Solution: NCF10 = ($40,000 – $29,000)(1 – 0.4) + $12,000 + $9,000(1 – 0.4) = $24,000 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 65. The Johnson Drum Company is planning to build a new factory. The purchase of the land, building the plant, and installation of equipment will take place over a two year period. The following are planned cash outflows: Year Cash Outflow 0 $3,500,000 1 $4,750,000 2 $6,100,000 Johnson Drum’s cost of capital is 14%, and its marginal tax rate is 35%. What is the NINV measured in present value terms today? a. $14,350,000 b. $12,356,650 c. $9,327,500 d. $8,035,788 ANSWER: b RATIONALE: Solution: Year Cash Outflow PVIF PV of NINV 0 $3,500,000 1.000 $ 3,500,000 1 $4,750,000 0.877 4,165,750 2 $6,100,000 0.769 4,690,900 $12,356,650 66. Anderson Clayton will purchase a new pellet mill that replace an older, less efficient, mill. The new mill costs $360,000 and shipping costs are $10,000. Improving the steam lines to the new mill will cost an additional $22,000. The old mill has a book value of $25,000 and can be sold for $12,000. The installation of the new mill will cause inventories to increase by $8,000, accounts receivable will go up $20,000, and accounts payable will increase $10,000. If Anderson Clayton has a marginal tax rate of 40%, what is the NINV for the new mill? a. $392,800 b. $412,800 c. $374,800 d. $398,000 ANSWER: a Solution: RATIONALE: Installed cost $392,000 Less: salvage – 12,000 Less: tax savings on sale – 5,200 Add: increase in NWC 18,000 $392,800 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 67. A Lotta Bread Corp. is replacing an entire baking line that was purchased for $420,000 and currently has a book value of $60,000. The new, more efficient line, will cost $940,000 installed and can be depreciated as a 7-year MACRS asset. With the increased efficiency, Lotta expects annual revenues to increase by $425,000, and operating expenses to increase by $170,000. The older machine, which was being depreciated at the straight-line rate of $20,000/year, will be sold for $30,000. What are the net cash flows for year 2? Assume the firm’s marginal tax rate is 40% and that the year 2 depreciation rate is 24.49%. a. $26,996 b. $332,206 c. $237,082 d. $383,206 ANSWER: c RATIONALE: Solution: Year 2 depreciation = $940,000(0.2449) = $230,206 Change Dep (Yr. 2) = $230,206 – $20,000 = $210,206 NCF2 = ($425,000 – $170,000 – $210,206)(0.6) + $210,206 = $237,082 68. Parker Chemicals purchased a hexene extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It can be sold today for $10,000. Parker is considering purchasing a new more efficient extractor that would cost $270,000 installed and would be depreciated as a 10-year MACRS asset. The company’s marginal tax rate is 40%. Determine the NINV if the old extractor is sold and the new one is purchased. a. $252,000 b. $228,000 c. $260,000 d. $248,000 ANSWER: d Solution: RATIONALE: Cost of extractor $270,000 Sale of old extractor – 10,000 Tax savings – 12,000 NINV = $248,000 Dep. (old extractor) = $120,000/15 = $8,000 per year Book value (old extractor = $120,000 – $80,000 = $40,000 Tax savings = ($40,000 – $10,000)(0.4) = $12,000 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 69. Parker Chemicals purchased a hexene extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It can be sold today for $10,000. Parker is considering purchasing a new more efficient extractor that would cost $270,000 installed and would be depreciated as a 10-year MACRS asset. (The depreciation rate for year one is 10 percent for this asset.) The company’s marginal tax rate is 40%. If the new extractor is purchased, annual revenues will increase by $10,000 and annual operating expenses will decrease by $10,000. What is the net cash flow in year 1? a. $7,600 b. $19,600 c. $24,200 d. $600 ANSWER: b RATIONALE: Solution: Dep. (old extractor) = $120,000/15 = $8,000/year Dep1 (new extractor) = $270,000(.10) = $27,000 NCF = ($10,000 – (–$10,000) – $19,000)(1 – 0.4) + $19,000 = $19,600 70. Com-Cat is considering expanding their current production facility. This year Com-Cat had an operating income (EBIT) of $760,000, interest expenses of $120,000, depreciation expenses of $45,000, and capital expenditures of $160,000. Next year, after the expansion is completed, operating income is expected to be $880,000, interest expenses will remain at $120,000, but depreciation will increase to $61,000. To support the expansion, cash is expected to increase by $5,000, accounts receivable by $12,000, inventories by $8,000, and accounts payable by $7,000. What is the change in Com-Cat’s net operating cash flows attributable to this project, if the tax rate is 40%? a. $80,400 b. $88,000 c. $106,000 d. $70,000 ANSWER: d RATIONALE: Solution: NCF = ($880,000 – $760,000)(1 – 0.40) + ($61,000 – $45,000) – ($5,000 + $12,000 + $8,000 – $7,000) = $70,000 71. The Weis Corp. purchased a new conveyor system to replace an older less automated system. The old system, which was 10 years old, was being depreciated on a straight line basis over its 20-year life at $25,000 per year. The new system will be depreciated as a 7-year asset for MACRS purposes. The more efficient machine, which costs $520,000 installed, will reduce operating costs by $74,000 per year. Compute the net cash flows in year 3 for the new system. Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $71,840 b. $80,779 c. $68,600 d. $149,917 ANSWER: a RATIONALE: Solution: Dep3 = $520,000(0.18) = $93,600 NCF3 = [$74,000 – ($93,600 – $25,000)](1 – 0.40) + ($93,600 – $25,000) = $71,840 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 72. Seduck has just replaced a set of hydraulic screens that had been in operation for 6 years with a newer screening system that cost $180,000 installed. The old system cost $140,000 and had been depreciated as a 10-year MACRS asset. Its salvage value is $10,000. What is the NINV for the new equipment? Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (10-Year Depreciation Schedule: 10%, 18%, 14%, 12%, 9%, 7%, 7%, 7%, 7%, 6%, 3%) a. $170,000 b. $157,200 c. $202,514 d. $151,228 ANSWER: b RATIONALE: Solution: Book value = $140,000(.30) = $42,000 Tax savings = ($42,000 – $10,000).40 = $12,800 Cost $180,000 Salvage – 10,000 Tax savings – 12,800 NINV $157,200 73. Martin Tartans, Inc. is considering the purchase of a new argyle sock knitting machine to replace a less automated one. The new machine will cost $220,000 plus $30,000 for shipping and installation. The machine being replaced was purchased five years ago for $140,000 and depreciated as a 7-year MACRS property. It can be sold for $24,000. Boll Mills has a marginal tax rate of 35%. Compute the NINV for the project. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $250,000 b. $226,000 c. $221,298 d. $223,620 ANSWER: d RATIONALE: Solution: Book value = $140,000(0.22) = $30,800 Tax savings = ($30,800 – $24,000)(0.35) = $2,380 New Machine Cost $220,000 Cost of Shipping & Installation 30,000 Salvage of Value of Old Machine (24,000) Tax Savings (2,380) Net Investment $223,620 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 74. Pixaire purchased a new mixer to replace an older system. The older system which cost $100,000 is 5 years old now and was being depreciated over a MACRS life at 7 years. The new mixer, which will cost $270,000, will also be depreciated as a 7 year asset for MACRS purposes. The new mixer is expected to increase revenues by $64,000 with no additional operating expenses. Determine the net operating cash flows in year 2 for the new mixer. Assume a 40% tax rate. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $66,974 b. $66,124 c. $61,277 d. $64,229 ANSWER: c RATIONALE: Solution: Change in depreciation = 270,000(.25) – 100,000(.09) = $58,500 CF = (64,000 – 58,500)(1 –.4) + $58,500 = $61,800 75. Rough & Tumble Clothiers is considering the purchase of a new loom to replace a less efficient one. The new machine will cost $240,000 including installation. The machine being replaced was purchased 5 years ago for $150,000 and is being depreciated as a 7-year MACRS property. It can be sold for $40,000. Compute the NINV for this project if KC has a marginal tax rate of 40%. Use the rounded MACRS schedule listed below: (7-Year Depreciation Schedule: 14%, 25%, 18%, 12%, 9%, 9%, 9%, 4%) a. $200,000 b. $197,386 c. $202,614 d. $216,000 ANSWER: c RATIONALE: Solution: Book value = $150,000 ×.22 = $33,000 Tax on gain from sale = ($40,000 – 33,000) ×.40 = $2,800 Cost of new machine $240,000 Salvage value of old machine (40,000) Tax due on sale of old machine 2,800 Net investment $202,800 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 76. Adler is replacing its old packing line with a more efficient line. The old line was being depreciated on a straight-line basis at a rate of $20,000 per year. The old machine has a current book value of $100,000. The new line, which costs $910,000, will be depreciated on a 10-year MACRS schedule. The more efficient operation is expected to increase revenues by $50,000 per year and reduce annual operating costs by $80,000. Compute the net cash flows for Adler in year 2. Assume Adler has a marginal tax rate of 40%. Use the rounded MACRS schedule listed below: (10-Year Depreciation Schedule: 10%, 18%, 14%, 12%, 9%, 7%, 7%, 7%, 7%, 6%, 3%) a. $143,520 b. $135,520 c. $39,520 d. $47,520 ANSWER: b RATIONALE: Solution: Dep2 = $910,000(0.18) = $163,800 Change in depreciation = $163,800 - $20,000 = $143,800 NCF2 = [$50,000 - (-$80,000) – $143,800](1 – 0.40) + $143,800 = $135,520 77. The difference between a capital expenditure and an operating expenditure is that a capital expenditure: a. is expected to generate returns greater than 10% b. involves replacement of a money market account with three-month treasury bills. c. is expected to generate future cash benefits lasting longer than one year. d. involves a combined effort of the accounting department and the marketing department. ANSWER: c 78. Of the following, an example of a component of a firm’s cost of capital is: a. Repurchase of company stock. b. Investment of corporate funds into a money market account. c. The purchase of another company’s bonds. d. The return on common stock required by investors. ANSWER: d 79. 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: a. independent project b. qualified project c. mutually exclusive project d. contingent project ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 9: Capital Budgeting and Cash Flow Analysis 80. All of the following are reasons that capital investment analysis must be performed correctly EXCEPT: a. Determine synergy of the venture. b. Establish global markets. c. Determine potential risks. d. Chart the future course of a company. ANSWER: b 81. A term meaning that the firm has limited funds and must choose only those projects that will be profitable is: a. capital refunding b. capital debt c. capital rationing d. capital choice ANSWER: c 82. Determine if this project is profitable under the following circumstances: A company is undertaking a new project. The specialized equipment that needs to be bought has an expense of $28,000. In addition, permits and licenses are required which will cost $1500. Employee training will be an additional $46,000 expenditure. To produce the merchandise, raw materials are required that will cost $48,000 and this project will generate cash flows of $25,000 per year for 10 years. The cost of capital for this project is 12%. a. Yes, the project is acceptable with a net present value equaling about $17,756. b. Yes, the project is acceptable with a net present value equaling about $48,257. c. No, the project is not acceptable with a net present value equaling about –$15,275. d. No, the project is not acceptable with a net present value equaling about –$18,000. ANSWER: a RATIONALE: Solution using a financial calculator: Determine the initial expense: $28,000 + $1,500 + $46,000 + $48,000 = $123,500 initial investment Determine the NPV using the TIBAII: CF0 = -123,500 CF1 = 25,000 F1 = 10 I = 12 NPV = $17,755.58 83. Projects are often classified based on the type of capital expenditure. All of the following are project classifications EXCEPT: a. projects generated by growth opportunities b. projects generated by cost reduction opportunities c. projects generated to meet legal requirements and health and safety standards d. projects generated to meet the needs of customers ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 9: Capital Budgeting and Cash Flow Analysis © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 9: Capital Budgeting and Cash Flow Analysis 84. List the steps that a firm uses in the capital budgeting process: ANSWER: The steps in the process are: 1. Generate capital investment project proposals. 2. Estimate cash flows. 3. Evaluate alternatives and select projects to be implemented. 4. Review the project’s performance after it has been implemented, and post auditing the performance of the project after its termination. 85. What are some of the different outlays that may be classified as capital expenditures? ANSWER: 1. The purchase of new equipment, real estate, or a building for improved service or expansion purposes. 2. The replacement of existing equipment. 3. Expenditures for an advertising campaign. 4. Expenditures for research and development. 5. Investments in permanent increases of target inventory or levels of accounts receivable. 6. Employee education and training 7. The refunding of an old bond issue 8. Lease-versus-buy analysis 9. Merger and acquisition evaluation. 86. What are the principles that should be applied when estimating cash flows for capital budgeting purposes? ANSWER: 1. Cash flows should be measured on an incremental basis. 2. Cash flows should be measured on an after-tax basis. 3. All the indirect effects of a project should be included in the cash flow calculations. 4. Sunk costs should not be considered when evaluating a project. 5. The value of resources used in a project should be measured in terms of their opportunity costs. 87. There are four ways tax consequences may affect the after-tax net proceeds received from the sale of an asset. Describe the four ways and the tax impact. ANSWER: 1. Sale of an asset for its book value: There is no gain or loss on the sale and thus no tax consequences. 2. Sale of an asset for less than its book value: This results in a capital loss thus reducing the company’s tax liability equal to the loss times the company’s marginal tax rate. 3. Sale of an asset for more than its book value but less than the original purchase price: The IRS treats this transaction as a recapture of depreciation and the firm’s taxes increase by the gain times the marginal tax rate. 4. Sale of an asset for more than its original purchase price: This transaction results in recaptured depreciation for all money received up to the purchase price. The difference between the sale price and the original purchase price is treated as a capital gain which is taxed at the capital gains rate for corporations. The end result is taxes due on the recaptured depreciation plus taxes due on the long-term capital gain. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 9: Capital Budgeting and Cash Flow Analysis 88. List the reasons that the marginal cost of capital schedule increases as more funds are sought in the capital markets. ANSWER: The reasons that the MCC schedule increases are: 1. Investors’ expectations about the firm’s ability to successfully undertake a large number of new projects. 2. The business risk to which the firm is exposed because of its particular line of business. 3. The firm’s financial risk, which is due to its capital structure. 4. The supply and demand for investment capital in the capital market. 5. The cost of selling new stock, which is greater than the cost of retained earnings. 89. In classifying investment projects, there are several types of capital expenditures. List them. ANSWER: Projects can be grouped as: 1. Projects generated by growth opportunities. 2. Projects generated by cost reduction opportunities. 3. Projects generated to meet legal requirements and health and safety standards. 90. Why should sunk costs not be considered when evaluating a project? ANSWER: Sunk costs are outlays that have already been made. Because sunk costs cannot be recovered, they should not be considered in the decision to accept or reject a project. The only relevant costs associated with a project are the incremental outlays that will be made from the point of undertaking the project. 91. What is the marginal cost of capital and why does the MCC schedule increase as more funds are sought in the capital markets? ANSWER: It is the cost of successive increments of capital acquired by the firm. The MCC schedule increases as more funds are sought in the capital markets. This increase is a result of: 1. investors’ expectations about the firm’s ability to successfully undertake a large number of new projects. 2. the business risk to which the firm is exposed because of its particular line of business. 3. the firm’s financial risk, which is due to its capital structure. 4. the supply and demand for investment capital in the capital market. 5. the cost of selling new stock, which is greater than the cost of retained earnings. 92. Most existing products become obsolete. For a firm to continue to grow they must do all of the following EXCEPT: a. move all production to the firm’s existing facilities for economies of scale b. generate research and development investment proposals c. invest in marketing research d. invest in new plants ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 9: Capital Budgeting and Cash Flow Analysis 93. Projects that begin with an initial investment and then is expected to generate a stream of cash inflows is considered: a. a contingent project b. a nonconventional project c. a normal project d. a non-normal project ANSWER: c 94. What type of tax consequence is associated with the recovery of net working capital? a. A firm must pay tax and a penalty. b. There is no tax consequence c. The firm must pay capital gains tax d. The firm must pay ordinary income tax ANSWER: b 95. There are several reasons why managers might produce biased cash flow estimates when preparing capital expenditure project proposals. List some of them. ANSWER: The reasons that managers might produce biased cash flow estimates when preparing capital expenditure proposals are: 1. The manager might be tempted to overestimate the revenues or underestimate the costs associated with the project if the manager is attempting to expand the resource base over which he or she has control. 2. Because managerial compensation is sometimes tied to the span of job responsibilities, managers may be tempted to expand this span of control at the expense of other areas of the firm. 3. Some firms tie employee compensation to performance relative to stated objectives. If a manager is confident that the best estimate of the cash flows from a proposed project is sufficiently large to guarantee project acceptance, the manager may be tempted to reduce these cash flow estimates to a level below the “most likely outcome” level, confident that the project will continue to be viewed as an acceptable investment and that it will be funded. 96. A conventional project can also be considered: a. a normal project b. a project that has both positive and negative cash flow patterns c. one that has a high required rate of return d. non-normal project ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.