1) Side effects such as erosion should be considered in a capital budgeting decision.

Transcription

1 Questions Chapter 10 1) Side effects such as erosion should be considered in a capital budgeting decision. [B] :A project s cash flows should include all changes in a firm s future cash flows. This includes side effects. Review section ) The approach for computing project operating cash flow explicitly measures the depreciation-related tax benefit associated with an investment. [A] stand-alone [B] bottom-up [C] top-down [D] tax shield [E] traditional [A] :This is not a method of computing operating cash flow. Review section [B] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project. Review section [C] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project. Review section [E] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project. Review section ) To accurately reflect the costs associated with a project, you should exclude interest expenses in the computation of the operating cash flows. [B] :Interest expenses result from financing, not operating choices. Review section ) A sunk cost is an incremental cash flow. [A] :Sunk costs are costs that have been incurred and cannot be removed. Therefore, they are not incremental cash flows. Review section ) An opportunity cost is the most valuable alternative that is given up if a particular investment is undertaken. [B] :This is the definition of an opportunity cost. Review section ) The managers of Poncho Parts, Inc. plan to manufacture engine blocks for classic cars from the 1960s. They expect to sell 250 blocks annually for the next 5 years. The necessary foundry and machining equipment will cost a total of $800,000 and will be depreciated on a straight-line basis to zero over the project's life. The firm expects to be able to sell the equipment for $150,000 at the end of 5 years. Labor and materials costs total $500 per engine block, fixed costs are $125,000 per year. Assume a 35 percent tax rate and a 12 percent discount rate. What is the expected after-tax cash flow to the firm when the equipment is sold in year five? [A] $65,000 [B] $97,500 [C] $100,000

2 [D] $115,000 [E] $120,125 [A] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to $52,500. Review section [C] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to $52,500. Review section [D] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to $52,500. Review section [E] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to $52,500. Review section ) Given the following information and assuming straight-line depreciation to zero, what is the internal rate of return of this project? Initial investment = $400,000; life = 4 years; cost savings = $125,000 per year; tax rate = 34 percent; discount rate = 12 percent. The fixed assets will be sold for $20,000 at the end of year 4. [A] 6.25 percent [B] 7.51 percent [C] 8.15 percent [D] 9.43 percent [E] percent [A] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets to be $13,200? Review section [C] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets to be $13,200? Review section [D] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets to be $13,200? Review section [E] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets to be $13,200? Review section ) Incremental cash flows are the difference between a firm's future cash flows if a project is accepted and the future cash flows if the project is rejected. [B] :This is the definition of an incremental cash flow. Review section ) You are considering investing in a cost cutting proposal. Net income from the project is expected to equal $27.50 each of the three years of the project's life. The process has an initial cost of $125 and will be depreciated straightline over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent. What is the value of the tax shield in each period from the investment in the process? [A] $6.80 [B] $8.50 [C] $14.17 [D] $27.50 [E] $41.67 [A] :Did you find the annual depreciation to be $41.67? Review section [B] :Did you find the annual depreciation to be $41.67? Review section [D] :Did you find the annual depreciation to be $41.67? Review section [E] :Did you find the annual depreciation to be $41.67? Review section ) Which of the following statements are correct? I. Setting the bid price requires finding the point at which NPV is zero. II. In a cost-cutting proposal the reduction in costs has the same effect as an increase in sales. III. Equivalent annual cost is used to evaluate mutually exclusive projects with different lives if the projects are expected to be replicated forever. [A] III only [B] I and II only

3 [C] I and III only [D] II and III only [E] I, II, and III [A] :Correct, but there is at least one other correct option. Review section [B] :Correct, but the third response is correct as well since it states important assumptions relating to EAC. Review section [C] :Correct, but the second response is correct as well. Review section [D] :Correct, but the first response is correct as well since it correctly describes the process of setting a bid price. Review section ) Which one of the following describes the "tax shield" approach to computing operating cash flow? [A] EBIT + D - Taxes [B] NI + D [C] (S - C) X (1 - Tc) + D X Tc [D] S - C - Taxes [E] EBIT + D X - Tc [A] :This is the most general method of computing operating cash flow. Review section [B] :This is the bottom up approach. Review section [D] :This is the top down approach. Review section [E] :This is not one of the ways of computing operating cash flow. Review section ) Consider the following balance sheet entries: Entry : Beginning : Ending Accounts receivable (AR) : $250 : $270 Inventory (I) : $225 : $218 Accounts payable (AP) : $250 : $241 Which of the accounts represent(s) a cash outflow? [A] AR only [B] AP only [C] I only [D] AR and AP only [E] I and AP only [A] :This is a cash outflow but it is not the only one. Review section [B] :This is a cash outflow but it is not the only one. Review section [C] :If an asset account decreases it is a cash inflow. Review section [E] :If an asset account decreases it is a cash inflow. Review section ) Your company just purchased a new computer system for $130,000. Computers have a 5-year MACRS classification. What is the depreciation for this system in year 2? [A] $28,899 [B] $31,837 [C] $41,600 [D] $43,329 [E] $57,772 [A] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section [B] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section [D] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section [E] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section ) Total project cash flow is the same as cash flow from assets. That is, it is equal to operating cash flow minus changes in net working capital minus net capital spending.

4 [B] :This is the definition of total project cash flow from chapter 10 and cash flow from assets from chapter 2. Review section ) A project costs $20,000, will be depreciated straight-line to zero over its 3-year life, will require a net working capital investment of $5,000 up front, has a tax rate of 34 percent and a required return of 10 percent. The fixed assets will be sold for $2,000 at the end of year three. The project generates an operating cash flow of $13,000. What is the project's net present value? [A] $10,724 [B] $11,033 [C] $12,077 [D] $13,426 [E] $15,942 [A] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of NWC, and $1,320 from the sale of the fixed assets? Review section [B] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of NWC, and $1,320 from the sale of the fixed assets? Review section [D] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of NWC, and $1,320 from the sale of the fixed assets? Review section [E] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of NWC, and $1,320 from the sale of the fixed assets? Review section ) Given the following information and assuming straight-line depreciation to zero, what is the payback period for this project? Initial investment = $500,000; life = 5 years; cost savings = $160,000 per year; tax rate = 34 percent; discount rate = 13 percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your answer to the nearest 1/10th of a year) [A] 2.5 years [B] 3.6 years [C] 3.9 years [D] 4.4 years [E] The payback period is greater than the project's life [A] :Did you find the OCF to be $139,600? Review section [C] :Did you find the OCF to be $139,600? Review section [D] :Did you find the OCF to be $139,600? Review section [E] :The project does pay back prior to the end of its life. Did you find the OCF to be $139,600? Review section ) Your company purchased a piece of land five years ago for $150,000 and subsequently added $175,000 in improvements. The current book value of the property is $225,000. There are two options for future use of the land: 1) the land can be sold today for $375,000 after-tax; or 2) your company can destroy the past improvements and build a factory on the land. When evaluating the factory option, what amount, if any, should be included for the use of the land? [A] $0 [B] $200,000 [C] $225,000 [D] $325,000 [E] $375,000 [A] :What about the opportunity cost? Review section [B] :What is a sunk cost? Review section [C] :Is opportunity cost based on book value or market value? Review section [D] :Are sunk costs relevant for this project? Review section ) Your company just bought a new distillation unit for $130,000 to be used in R&&D. Such equipment has a 3-year MACRS classification. What is the book value of the distillation unit at the end of year 2? [A] $28,899 [B] $35,568 [C] $39,899 [D] $57,775 [E] $58,896

5 [B] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to arrive at the book value at the end of year two. Review section [C] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to arrive at the book value at the end of year two. Review section [D] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to arrive at the book value at the end of year two. Review section [E] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to arrive at the book value at the end of year two. Review section ) When we employ, we are evaluating a project on the basis of its incremental cash flows, thereby ignoring the other cash flows of the firm. [A] the stand-alone principle [B] the equivalence theorem [C] the law of one price [D] Bell's theorem [E] the equivalent annual cost procedure [B] :We have discussed no such theorem. Review section [C] :We have discussed no such law. Review section [D] :We have discussed no such theorem. Review section [E] :The EAC does rely on evaluating incremental cash flows, but it is not the term that describes this process in general. Review section ) What is the difference between a project s operating cash flow (OCF) and the project s cash flow (PCF)? [A] PCF = OCF plus the change in project change in net working capital minus plus project capital spending [B] OCF = PCF minus the project change in net working capital plus depreciation [C] OCF = PCF plus the project change in net working capital [D] PCF = OCF minus the project change in net working capital minus the project capital spending [E] PCF = OCF plus the depreciation tax shield. [A] :Are you plus and minus signs correct? Review section [B] :Please try again. Review section [C] :You are missing one variable in the equation. Review section [E] :Please try again. Review section ) When considering mutually exclusive investment projects with different lives that will not be replaced after they terminate, it is best to evaluate them using the method. [A] discounted payback [B] profitability index [C] equivalent annual cost [D] internal rate of return [E] net present value [A] :Although this is one way to evaluate the projects, this is not the best choice. Review section 9.3. [B] :This method should not be used for mutually exclusive investments. Review section 9.6. [C] :This would be correct if they were going to be replaced, but they aren't. Review section [D] :This method should not be used for mutually exclusive investments. Review section ) You are given the following information about equipment that is required for your business. Assume that the equipment will be replaced as it wears out and that straight-line depreciation to zero is used. The required return is 15 percent. Ignore taxes. Machine A has an initial cost of $200,000, an operating cost per year of $15,000, and an expected life of 8 years. Machine B has an initial cost of $300,000, an operating cost per year of $17,500, and an expected life of 10 years. What is the equivalent annual cost of machine A? [A] -$301,664 [B] -$201,676 [C] -$48,163 [D] -$59,570 [E] -$22,437

6 [A] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section [B] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section [C] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section [E] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section ) You are given the following information about equipment that is required for your business. Assume that the equipment will be replaced as it wears out and that straight-line depreciation to zero is used. The required return is 15 percent. Ignore taxes. Machine A has an initial cost of $200,000, an operating cost per year of $15,000, and an expected life of 8 years. Machine B has an initial cost of $300,000, an operating cost per year of $17,500, and an expected life of 10 years. What is the equivalent annual cost of machine B? [A] -$61,664 [B] -$77,276 [C] -$85,776 [D] -$90,163 [E] -$94,113 [A] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section [C] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section [D] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section [E] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section ) Your firm needs a computerized line-boring machine that costs $80,000, and requires $20,000 in maintenance for each year of its 3-year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. Assume the machine can be sold for $10,000 at the end of year three. What is the after-tax salvage value at the end of year 3? [A] $4,544 [B] $5,616 [C] $6,600 [D] $8,616 [E] $9,678 [A] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to $1, Review section [B] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to $1, Review section [C] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to $1, Review section [E] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to $1, Review section ) Which one of the following statements regarding operating cash flows (OCF) is correct? [A] In order to compute OCF, you need both a balance sheet and an income statement. [B] Changes in OCF will occur when cost of goods sold changes, all else equal. [C] Changes in OCF result directly from changes in financing. [D] OCF for a project can be found by subtracting depreciation from project net income. [E] An increase in depreciation will cause a decrease in OCF. [A] :Which element of OCF is found on the balance sheet? Review section [C] :Financing expenses are not included in OCF. Review section [D] :Depreciation can be added to net income to compute OCF as long as the interest expense is equal to zero. Review section [E] :If you review the tax-shield approach to computing OCF, you will see that this cannot be the case. Review section ) You are bidding to supply 3 jets per year for each of the next three years to the Navy. To get set up, you will need $10 million in equipment which will be depreciated straight-line to zero over three years and have no salvage value. Total fixed costs per year are $5 million and variable costs are $7 million per jet. The tax rate is 30 percent and the required return is 10 percent. A reasonable bid, which leaves room for a small margin of error, would be a price per jet of million.

7 [A] $5 [B] $6 [C] $9 [D] $11 [E] $32 [A] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is $3,333,333 per year. Now work backwards up the income statement to find sales. Review section [B] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is $3,333,333 per year. Now work backwards up the income statement to find sales. Review section [C] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is $3,333,333 per year. Now work backwards up the income statement to find sales. Review section [E] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is $3,333,333 per year. Now work backwards up the income statement to find sales. Review section ) Given the following information and assuming straight-line depreciation to zero, what is the NPV for this project? Initial investment in fixed assets = $800,000; net working capital requirement = $200,000; life = 4 years; cost savings = $400,000 per year; tax rate = 35 percent; discount rate = 12 percent. The fixed assets will be sold for $100,000 at the end of year 4. (Round to the nearest whole dollar) [A] $95,101 [B] $105,967 [C] $133,560 [D] $170,738 [E] $204,289 [A] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital plus $65,000 for the after-tax sale of the fixed assets? Review section [B] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital plus $65,000 for the after-tax sale of the fixed assets? Review section [C] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital plus $65,000 for the after-tax sale of the fixed assets? Review section [E] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital plus $65,000 for the after-tax sale of the fixed assets? Review section ) You are considering investing in a cost cutting proposal. Net income from the project is expected to equal $27.50 each of the three years of the project's life. The process has an initial cost of $125 and will be depreciated straightline over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent. What is operating cash flow in each of the three periods? [A] $36.30 [B] $43.10 [C] $44.80 [D] $61.80 [E] $69.17 [A] :Did you find the annual depreciation to be $41.67? Review section [B] :Did you find the annual depreciation to be $41.67? Review section [C] :Did you find the annual depreciation to be $41.67? Review section [D] :Did you find the annual depreciation to be $41.67? Review section ) A firm experiences when the cash flows of a new project come at the expense of a firm's existing projects. [A] the stand-alone principle [B] sunk costs [C] erosion [D] capital analysis [E] a negative net present value [A] :This is not the term that fits this definition. Review section [B] :This is not the term that fits this definition. Review section [D] :This is not the term that fits this definition. Review section [E] :This is not the term that fits this definition. Review section 10.2.

8 30) Your company just bought some new equipment for its manufacturing plant. The equipment cost $130,000. Industrial equipment has a MACRS classification of 7 years. If the equipment will be sold at the end of year 3 for $85,000, what is the after-tax cash flow from the sale? The corporate tax rate is 34 percent. [A] $27,784 [B] $66,000 [C] $72,216 [D] $75,429 [E] $97,116 [A] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review section [B] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review section [C] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review section [E] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review section ) Which one of the following is correct concerning project evaluation? [A] Financing costs must be included in the cash flows of a proposed project because they are not accounted for elsewhere. [B] The stand-alone principle calls for evaluation of a project based on the project's incremental cash flows. [C] Changes in net working capital are excluded from the incremental cash flows of a project. [D] When fixed assets are sold at the end of a project, there are usually no tax consequences of the sale. [E] The decision to use straight-line depreciation or MACRS depreciation is used will have no impact on the net present value of a project. [A] :Financing costs are not incremental cash flows of a project. Review section [C] :Changes in net working capital are considered to be incremental cash flows in capital investment analysis. Review section [D] :There will be tax consequences if the sale price and book values differ. Review section [E] :Using MACRS depreciation will increase the NPV because it increases project cash flows in the early years of a project. Review section ) Which one of the following is NOT a definition of operating cash flow? [A] EBIT + D - Taxes [B] NI + D [C] (S - C) X (1 - Tc) + D X Tc [D] S - C - Taxes [E] S - C - EBIT X (1 - Tc) [A] :This is the most general method of computing OCF. Review section [B] :This is the bottom-up approach. Review section [C] :This is the tax shield approach. Review section [D] :This is the top down approach. Review section ) Which one of the following is NOT considered to be an incremental cash flow in capital budgeting analysis? [A] opportunity cost [B] erosion [C] additions to NWC [D] sunk cost [E] fixed asset salvage values at the end of the project [A] :This is considered to be an incremental cash flow in capital investment analysis. Review section [B] :This is considered to be an incremental cash flow in capital investment analysis. Review section [C] :This is considered to be an incremental cash flow in capital investment analysis. Review section [E] :This is considered to be an incremental cash flow in capital investment analysis. Review section 10.2.

9 34) Your firm needs a computerized line-boring machine that costs $80,000, and requires $20,000 in maintenance for each year of its 3-year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is the depreciation tax shield for year 3? [A] $2,016 [B] $3,513 [C] $4,031 [D] $5,222 [E] $5,719 [A] :The appropriate MACRS percentage for year 3 is percent, so the depreciation is $11,856 for that year. Review section [B] :The appropriate MACRS percentage for year 3 is percent, so the depreciation is $11,856 for that year. Review section [D] :The appropriate MACRS percentage for year 3 is percent, so the depreciation is $11,856 for that year. Review section [E] :The appropriate MACRS percentage for year 3 is percent, so the depreciation is $11,856 for that year. Review section ) It is important to identify and use only incremental cash flows in capital investment decisions: [A] because they are the simplest to identify. [B] only when the stand alone principle fails to hold. [C] because ultimately it is the change in a firm's overall future cash flows that matter. [D] in order to accommodate unforeseen changes that might occur. [E] whenever sunk costs are involved. [A] :Actually, they can be quite difficult to identify. Review section [B] :You should use incremental cash flows when the stand-alone principle holds. Review section [D] :You cannot accommodate changes you can't foresee. Review section [E] :Sunk costs should never be a part of the analysis. Review section ) Given the following information and assuming straight-line depreciation to zero, what is the discounted payback period for this project? Initial investment = $500,000; life = 5 years; cost savings = $160,000 per year; salvage = $30,000 in year 5; tax rate = 34 percent; discount rate = 13 percent. [A] more than 3.0 but less than 3.5 years [B] more than 3.5 but less than 4.0 years [C] more than 4.0 but less than 4.5 years [D] more than 4.5 but less than 5.0 years [E] The discounted payback period is greater than the project's life [A] :Did you find the OCF to be $139,600? Review section [B] :Did you find the OCF to be $139,600? Review section [C] :Did you find the OCF to be $139,600? Review section [E] :If you include the $19,800 after-tax cash flow from the sale of fixed assets at the end of the project, the project does pay back on a discounted basis. 37) You are advising a friend who is attempting to decide whether or not to drop one of the courses they are currently enrolled in. If they do, they will forfeit half of the money spent on tuition. Which of the following conclusions drawn by your friend is consistent with capital budgeting principles? I. Remaining in the class incurs opportunity cost because they have to reduce the number of hours they are gainfully employed. II. The tuition is irrelevant to the decision because it is a sunk cost. III. The time and energy put into the course thus far is a sunk cost. [A] I only [B] I and II only [C] I and III only [D] II and III only [E] I, II, and III [A] :Correct, but there is at least one more correct option. Review section 10.2.

10 [B] :At least one of these choices is incorrect. Review section [D] :At least one of these choices is incorrect. Review section [E] :At least one of these choices is incorrect. Review section ) The incremental cash flows related to a capital investment project are easiest to identify when: [A] sunk costs exist. [B] opportunity costs are significant. [C] a proposed project has no effect on the current operations. [D] erosion of cash flow is expected to occur. [E] the project has no impact on total fixed assets. [A] :Sunk costs should never be a part of the analysis. Review section [B] :Opportunity costs can be difficult to identify and value. There is a better response. Review section [D] :Erosion can be difficult to identify and value. There is a better response. Review section [E] :Even a project that requires no investment in fixed assets can be difficult to evaluate if erosion and opportunity costs exist. There is a better choice. Review section ) Pro forma statements: [A] are generally created by first estimating production costs. [B] for a proposed project generally consider only the first year of the project. [C] recap a firm s activities for the past year. [D] should only be prepared when considering a capital budgeting project. [E] should use realistic assumptions. [A] :The first step generally is to estimate sales. Go back and review section 4.2. [B] :Pro forma statements are generally prepared for the life of a project, which is normally more than one year. Review section [C] :Pro forma statements look at the future, not the past. Review section [D] :You should always be looking ahead. Thus, pro forma statements should be prepared on a routine basis. Review section ) Consider a $10,000 machine that will reduce pre-tax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a scrap value of zero after five years. For simplicity, assume straightline depreciation to zero, a marginal tax rate of 34 percent, and a required return of 10 percent. The net present value, rounded to the nearest whole dollar, is: [A] $83. [B] $449. [C] $689. [D] $827. [E] $1,235. [B] :Did you find the OCF to be $2,660? Review section [C] :Did you find the OCF to be $2,660? Review section [D] :Did you find the OCF to be $2,660? Review section [E] :Did you find the OCF to be $2,660? Review section ) In setting the bid price, we attempt to set a price at which the firm will "break even" in a financial sense. Which one of the following equations does NOT hold at the lowest acceptable bid price? [A] AAR = required return [B] NPV = 0 [C] discounted payback = the life of the project [D] IRR = required return [E] PI = 1 [B] :When the NPV is zero, the firm expects to earn at least its required rate of return. Review section [C] :When the discounted payback is equal to the project's life, the NPV will be zero. Review section [D] :When the IRR is equal to the required return, the NPV will be zero. Review section [E] :When the PI is equal to one, the NPV will be zero. Review section 10.6.

11 42) Your firm is selling a machine it purchased two years ago. The selling price is approximately 50 percent less than the book value of the machine. As a result of this transaction, your firm has a tax benefit in the amount of the tax rate multiplied by the difference between the: [A] selling price and the original purchase price. [B] original purchase price and the book value. [C] selling price and the current market value. [D] selling price and the book value. [E] original purchase price and the current market value. [A] :Since the machine must have been partially depreciated over the past two years, the original purchase price is no longer relevant. Review section [B] :Since the machine must have been partially depreciated over the past two years, the original purchase price is no longer relevant. Review section [C] :The selling price and current market value are the same thing. Review section [E] :Since the machine must have been partially depreciated over the past two years, the original purchase price is no longer relevant. Review section ) Consider the following balance sheet entries: Entry : Beginning : Ending Accounts receivable (AR) : $250 : $270 Inventory (I) : $225 : $218 Accounts payable (AP) : $250 : $241 Which of the accounts represent(s) a cash inflow? [A] AR only [B] AP only [C] I only [D] AR and AP only [E] I and AP only [A] :If an asset account increases it is a use of cash. Review section [B] :If a liability account decreases it is a use of cash. Review section [D] :If an asset account increases or a liability account decreases it is a use of cash. Review section [E] :If a liability account decreases it is a use of cash. Review section ) Which of the following is (are) explicitly considered in the calculation of MACRS depreciation? I. actual expected economic life of the asset II. asset cost III. asset property class IV. expected salvage value [A] IV only [B] II and III only [C] I and IV only [D] III only [E] I, II, III, and IV [A] :There is no consideration of salvage value with MACRS depreciation. Review section [C] :At least one of these choices is incorrect. Review section [D] :Correct, but there is at least one more correct option. Review section [E] :At least one of these choices are incorrect. Review section ) The depreciation tax shield is the tax savings which results from the depreciation deduction. [B] :This is the definition of the depreciation tax shield. Review section 10.5.

12 46) The government has been trying to decide whether or not to purchase any of the new, advanced missiles it has developed. One of the arguments in favor of purchasing the missiles is that so much money has been spent on their development that it would be a waste of money not to buy any. What is the major problem with this argument? [A] It ignores the opportunity cost of the money that has been spent. [B] It includes sunk costs in the decision. [C] It includes opportunity costs in the decision. [D] It includes changes in net working capital. [E] It includes financing costs in the decision. [A] :Money that has already been spent is not an opportunity cost. Review section [C] :Money that has already been spent is not an opportunity cost. Review section [D] :Changes in net working capital are not the issue here. Review section [E] :Financing costs are not the issue here. Review section ) Which one of the following statements regarding cash flow is correct? [A] Cash flow and net income are the same when the interest expense is ignored. [B] Interest expense is part of the operating cash flow of a project. [C] In evaluating capital budgeting decisions, cash flows should be valued on a pre-tax basis. [D] After-tax cash flow is usually identical to accounting profits. [E] Incremental cash flows should include opportunity costs but not sunk costs. [A] :What about depreciation? Review section [B] :Is interest related to capital budgeting or capital structure? Review section [C] :Are taxes a cash or a noncash expense? Review section [D] :What about depreciation or other non-cash expenses? Review section ) Given the following information and assuming straight-line depreciation to zero, what is the net present value of this project? Initial investment = $400,000; life = 5 years; cost savings = $150,000 per year; tax rate = 34 percent; discount rate = 14 percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your answer to the nearest whole dollar.) [A] -$149,841 [B] -$33,117 [C] $0 [D] $19,800 [E] $43,538 [A] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5? Review sections 10.3 and [B] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5? Review sections 10.3 and [C] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5? Review sections 10.3 and [D] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5? Review sections 10.3 and ) A firm is considering a project that would increase accounts receivable by $10,000, accounts payable by $35,000, and inventory by $30,000. Which one of the following is true if the project is accepted? [A] sales will increase [B] current assets will decrease [C] net working capital will decrease [D] project net working capital will be a source of cash [E] current liabilities will increase [A] :You cannot make this assumption based on the information given. Review section [B] :You cannot make this assumption based on the information given. Review section [C] :Current assets have increased faster than current liabilities. Has NWC decreased if this is true? Review section [D] :Assets increased faster than liabilities so uses of cash have outpaced sources. Review section 10.4.

13 50) In general, adopting MACRS depreciation instead of straight-line depreciation will increase the net present value of a project. [B] :By adopting MACRS depreciation, the tax benefits of depreciation are shifted closer to the present, raising the present value of the project cash flows. Review section ) Assume that over the life of a project, net working capital is maintained at an amount equal to the initial investment. If so, net working capital can be excluded from the net present value computation, since the outflow at time zero is exactly offset by an equal inflow at the end of the project's life. [A] :The inflow at the end of the project must be discounted to the present, making it less valuable than the amount initially invested. Review section ) The equivalent annual cost method of evaluating projects applies to projects that have economic lives and assets which will [A] equal; never be replaced. [B] equal; be replaced more or less indefinitely. [C] different; never be replaced. [D] different; be replaced more or less indefinitely. [E] either equal or different; never be replaced. [A] :You are totally wrong. Please try again. Review section [B] :You are only half right. Review section [C] :You are only half right. Review section [E] :You are totally wrong. Please try again. Review section ) Consider the following balance sheet entries: Entry : Beginning : Ending Accounts receivable (AR) : $250 : $270 Inventory (I) : $225 : $218 Accounts payable (AP) : $250 : $241 What is the net cash flow from net working capital? [A] -28 [B] -22 [C] -4 [D] 4 [E] 18 [A] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net change in I and sum these to find the total net cash flow. Review section [C] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net change in I and sum these to find the total net cash flow. Review section [D] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net change in I and sum these to find the total net cash flow. Review section [E] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net change in I and sum these to find the total net cash flow. Review section ) Which of the following describe relevant cash flows for the purpose of performing capital budgeting analysis? I. incremental cash flow II. tax shield III. changes in net working capital IV. changes in fixed assets [A] I and III only [B] I, II, and III only

14 [C] I and IV only [D] II, III, and IV only [E] I, II, III, and IV [A] :Correct, but there is at least one more correct option. Review section [B] :Why aren't additions to fixed assets relevant? Review section [C] :Correct, but there is at least one more correct option. Review section [D] :Why aren t incremental cash flows relevant? Review section ) When you set the net present value equal to zero in calculating your bid price you are: [A] going to earn a net income of zero on the project. [B] appropriately including opportunity costs in your analysis. [C] certain to be the lowest bidder since any lower price will result in a negative NPV. [D] assured of earning your firm's highest possible internal rate of return. [E] finding the price at which you expect to create zero wealth for your stockholders. [A] :Is net income always zero when the net present value is zero? Review section [B] :You should include opportunity costs if they exist but they are not discussed here. Review section [C] :Firms have different cost structures and operating characteristics, making it possible for another firm to have a lower financial break-even point than you have. Review section [D] :When you set the NPV equal to zero, you are expecting to earn a return equal to your required return. Review section ) Taxes are not an important consideration in evaluating capital investment proposals. [A] :Since taxes must be paid in cash, they are an important cash outflow that must be considered in capital budgeting decisions. Review section ) Given the following information and assuming straight-line depreciation to zero, what is the profitability index for this project? Initial investment = $500,000; life = 5 years; cost savings = $160,000 per year; tax rate = 34 percent; discount rate = 13 percent. The fixed assets will be sold for $10,000 at the end of year 5. [A] 0.45 [B] 0.74 [C] 0.99 [D] 1.65 [E] 1.98 [A] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be $6,600 at the end of year five? Review section [B] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be $6,600 at the end of year five? Review section [D] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be $6,600 at the end of year five? Review section [E] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be $6,600 at the end of year five? Review section ) The information you have on a proposed project includes the sales, net income, depreciation, and the initial investment. The easiest method for you to use to compute the operating cash flow is the method. [A] conventional [B] tax shield [C] bottom-up [D] top-down [E] depreciation first [A] :To use this approach, you would need to be able to compute earnings before interest and taxes which you cannot do given the information you have available. Review section [B] :To use this approach, you would need to know the tax rate. Review section 10.5.

15 [D] :To use this approach, you would need to know the amount of the taxes. Review section [E] :There is no such approach to computing operating cash flow. Review section ) Which one of the following describes the "bottom-up" approach to computing operating cash flow? [A] EBIT + D - Taxes [B] NI + D [C] (S - C) X (1 - Tc) + D X Tc [D] S - C -Taxes [E] NI + D - taxes [A] :This is the most general method of computing operating cash flow. Review section [C] :This is the tax shield approach. Review section [D] :This is the top down approach. Review section [E] :This is not one of the ways of computing operating cash flow. Review section ) Sunk cost is another term which describes opportunity cost. [A] :A sunk cost is a cost that has been incurred and cannot be recovered. How does this differ from an opportunity cost? Review section ) An increase in will usually represent a net cash inflow at the beginning or during the life of a project and an equal net cash outflow upon completion of the project. [A] accounts payable [B] inventory [C] accounts receivable [D] fixed assets [E] accounts receivable coupled with an identical increase in accounts payable [B] :This would be a cash outflow at the outset and an inflow at the end. Review section [C] :This would be a cash outflow at the outset and an inflow at the end. Review section [D] :This would be a cash outflow at the outset, but not necessarily an inflow at the end. Review section [E] :This would be a net cash flow of zero. Review section ) By using the tax shield approach for computing operating cash flows, you can: [A] obtain more accurate results than with the customary methods. [B] more readily verify what cash flows would be without interest expenses. [C] more readily identify the tax shield from interest deductions. [D] more readily identify the tax benefits of depreciation. [E] start with the bottom line, net income, and work backwards. [A] :The methods of computing operating cash flows are equally accurate. Review section [B] :The tax shield approach does not deal with interest expense. Review section [C] :The tax shield approach deals with depreciation, not interest expense. Review section [E] :This response describes the bottom-up approach, not the tax shield approach. Review section ) When we use the equivalent annual cost methodology, the projects under consideration have different economic lives and the related assets will be replicated more or less indefinitely. [B] :This is the definition of when the EAC method of evaluating projects is appropriate. Review section 10.6.

16 64) Which one of the following projects would increase net working capital the most? [A] purchasing land for a new baseball manufacturing plant [B] decreasing the amount of sales your firm makes on credit [C] decreasing the number of product lines your firm carries [D] converting a manufacturing process so that you produce goods only after a customer order has been received [E] using long-term bank credit to reduce payables [A] :This would increase fixed assets, not current assets. Review section [B] :This would decrease accounts receivable, thereby reducing net working capital. Review section [C] :This would decrease inventory, thereby reducing net working capital. Review section [D] :This would decrease inventory, thereby reducing net working capital. Review section ) Which one of the following is true about net working capital? [A] Projects in which a firm expands its operations and sales will generally not lead to changes in net working capital. [B] Changes in net working capital account for differences between accounting sales and costs and actual cash receipts and payments. [C] Net working capital is typically an expense at the beginning of a project and an equal inflow at the end, thus having no impact on NPV. [D] Dollar changes in the cash account and changes in net working capital are generally equal. [E] Net working capital is not considered an investment for the firm. [A] :The situation described here will generally lead to increases in net working capital. Review section [C] :You are forgetting to consider the time value of money when addressing the cash inflow at the end of the project. Review section [D] :Changes in the cash account are just one part of the changes in net working capital. Review section [E] :Net working capital is considered an investment. Review section ) In a cost cutting proposal, the net present value will generally be negative but the project will still be considered acceptable. [A] :Cost cutting proposals are handled just as any other capital budgeting project would be, meaning that a negative NPV should result in the project being rejected. Review section ) Which of the following methods for computing project operating cash flow could you use if the only income statement items you know are project net income and project depreciation? I. bottom-up approach II. top-down approach III. tax shield approach [A] I only [B] II only [C] III only [D] I and II only [E] I and III only [B] :You cannot compute this using just net income and depreciation. Review section [C] :You cannot compute this using just net income and depreciation. Review section [D] :You can compute only one of these using just net income and depreciation. Review section [E] :You can compute only one of these using just net income and depreciation. Review section ) The is the present value of a project's costs calculated on an annual basis. [A] internal rate of return [B] average accounting return [C] net present value [D] equivalent annual cost

17 [E] profitability index [A] :The IRR is reported as a percent, not as a present value. Review section [B] :The AAR is reported as a percent, not as a present value. Review section [C] :The NPV is not a present value on an annual basis. Review section [E] :The PI is a benefit to cost ratio, not a present value. Review section ) A project costs $60,000, will be depreciated straight-line to zero over its 4-year life, has a tax rate of 34 percent and a required return of 10 percent. The project generates an operating cash flow of $18,000 and the fixed assets will be sold for $7,000 at the termination of the project. What is the project's net present value? [A] $213 [B] $1,133 [C] $1,839 [D] $2,261 [E] $2,842 [B] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section [C] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section [D] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section [E] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section ) Your firm needs a computerized line-boring machine that costs $80,000, and requires $20,000 in maintenance for each year of its 3-year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is the annual after-tax maintenance cost? [A] $10,000 [B] $12,250 [C] $13,200 [D] $15,250 [E] $27,200 [A] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section [B] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section [D] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section [E] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section ) Assume a project requires additions to net working capital in each year of its life. All of the net working capital will be recovered at the end of the project. In this case, the present value of the net working capital recovery will exceed the total dollar outlays for net working capital. [A] :Although the amount recovered will be the same as the amount invested, the present value of the amount recovered will be lower due to discounting. Review section ) Which one of the following describes the "top-down" approach to computing operating cash flow? [A] EBIT + D - Taxes [B] S - C - Taxes + D [C] (S - C) X (1 - Tc) + D X Tc [D] S - C - Taxes [E] NI + D [A] :This is the most general method of computing operating cash flow. Review section [B] :This is not one of the ways of computing operating cash flow. Review section [C] :This is the tax shield approach. Review section [E] :This is the bottom up approach. Review section 10.5.