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1 Exam Name TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 1) Accounting profits are used to make capital budgeting decisions because generally accepted accounting principles ensure that profits are the best measure of a company's economic activity. 2) Capital budgeting decisions are based on free cash flow because free cash flow better reflects when money is received and available for reinvestment than account profits. 3) The guiding rule in deciding if a free cash flow is incremental is to look at the company with, versus without, the new project. 4) A grocery store decides to offer beer for sale and this decision results in more potato chip sales. This is an example of a synergistic effect. 5) Additional investment in working capital, even if it may be recovered at the end of a project, must be included in capital budgeting analysis because of the time value of money. 6) Sunk costs are cash outflows that will occur regardless of the current accept/reject decision, and therefore should be excluded from the analysis. 1) 2) 3) 4) 5) 6) 7) Overhead costs are sometimes incremental cash flows and other times are considered sunk costs. 7) 8) Interest payments on a loan obtained specifically to fund a new project should be considered an incremental cash flow for the new project when determining the accept/reject decision. 9) To be included in a capital budgeting analysis, all incremental free cash flows must be expensed on the company's books, otherwise generally accepted accounting principles will be violated. 10) In measuring cash flows we are interested only in the incremental or incremental after-tax cash flows that are attributed to the investment proposal being evaluated. 8) 9) 10) 11) The initial outlay for a new project is an example of an opportunity cost. 11) 12) Synergistic benefits from an investment project include cannibalism. 12) 1

2 13) A project's annual free cash flow is the change in operating cash flow less any change in net working capital and less any change in capital spending. MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 14) The calculation of incremental free cash flows over a project's life should include 14) A) labor and material saving. B) additional revenue. C) interest to bondholders. D) A and B. 13) 15) Eastlick Dairy invests in a new kind of frozen dessert called polar cream that becomes very popular. So many new customers come to the store that the sales of existing ice cream products are increased. The extra sales revenue A) should not be counted as incremental revenue for the polar cream project because the sales come from existing products. B) are cannibalized sales that should be excluded from the analysis. C) are synergistic effects that should be counted as incremental revenues for the polar cream project. D) should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring expense. 15) 16) Sunk costs are: 16) A) not deductible for tax purposes. B) not relevant in capital budgeting. C) recoverable. D) incremental. TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 17) In general, a project's free cash flows will fall in one of the following three categories: initial outlay, differential cash flows over the project's life, and the terminal cash flow. 18) If an old asset is sold for less than its book value the resulting loss will save the company taxes, hence lowering the cost of the project. 19) If an old asset is sold for its depreciated, or book, value, then no taxes result and there is no tax effect from the sale. 20) One example of a terminal cash flow is the recapture of the net working capital associated with the project. 17) 18) 19) 20) 21) The initial outlay of a project may be reduced by the after-tax salvage value of replaced equipment. 21) 2

3 22) A weakness in the capital budgeting process is the funds for an investment proposal obtained by issuing bonds, and the respective interest payments, are not considered in the capital budgeting process. 23) The initial outlay includes the immediate cash outflow necessary to purchase the asset and put it in operating order. 24) If the increase in net working capital is recovered entirely at the end of the project then it may be ignored. 25) Cash flows associated with a project's termination generally include the salvage value of the project net of any taxes associated with the sale. 22) 23) 24) 25) 26) Increasing depreciation expense results in a decrease of the incremental after-tax free cash flow. 26) 27) Increases in working capital needs should be included as part of the initial outlay of a project, but decreases in working capital for a project should not be considered because they are not guaranteed. 28) Any increase in interest payments caused by a project should be counted in the incremental cash flows. 29) Terminal cash flows are always positive because they result from the shutting down of a project with the sale of any assets with remaining value. 30) Proceeds from the issuance of new debt and principal payments upon maturity of debt used to finance a project should be included in the calculation of the project's after-tax cash flows. 31) Interest payments on debt are not included in a project's incremental cash flows, but are instead accounted for in the project's discount rate. 32) Depreciation is a non-cash deduction so it may be ignored in the calculation of a project's incremental after-tax cash flows. 33) Depreciation expense produces a cash inflow equal to the depreciation expense multiplied by the firm's marginal tax rate. 27) 28) 29) 30) 31) 32) 33) 3

4 34) TRL, Inc. has spent $2,000,000 in nonrefundable engineering fees in contemplation of building a convention center and the additional costs to complete the project are $18,000,000. The present value of all benefits the center will produce in its lifetime are $19,000,000, so TRL should not build the convention center. 34) 35) Free cash flow calculations can be broken down into three parts: cash flows from operations, cash flows associated with working-capital requirements, and financing cash flows relating to interest and dividend payments. 35) 36) An opportunity cost is a relevant incremental cost for capital budgeting decisions. 36) MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 37) Taste Good Chocolates develops a new candy bar and plans to sell each bar for $1. Taste Good predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold, and includes $1 million of incremental revenues in its capital budgeting analysis. A senior executive in the company believes that 1 million candy bars will be sold, but lowers the estimate of incremental revenue to $700,000. What would explain this change? A) a higher selling price for the new candy bars B) cannibalization of 300,000 of Taste Good Chocolates' other candy bars C) a lower discount rate D) excessive marketing costs to sell the 1 million candy bars 38) Laural Inc. is a household products firm that is considering developing a new detergent. In evaluating whether to go ahead with the new detergent project, which of the following statements is most correct? A) The company will produce the detergent in a building that they already own. The cost of the building is therefore zero and should be excluded from the analysis. B) The company will need to hire 10 new workers whose salaries and benefits will total $400,000 per year. Labor costs are not part of capital budgeting and should be excluded. C) The company will produce the detergent in a building that it renovated 2 years ago for $300,000. The $300,000 should be excluded from the analysis. D) The company will need to use some equipment that it could have leased to another company. This equipment lease could have generated $200,000 per year in after-tax income. The $200,000 should be excluded because the equipment can no longer be leased. 39) JW Enterprises is considering a new marketing campaign that will require the addition of a new computer programmer and new software. The programmer will occupy an office in JW's current building and will be paid $8,000 per month. The software license costs $1,000 per month. The rent for the building is $4,000 per month. JW's computer system is always on, so running the new software will not change the current monthly electric bill of $900. The incremental expenses for the new marketing campaign are: A) $8,000 per month. B) $13,000 per month. C) $9,000 per month. D) $13,900 per month. 37) 38) 39) 4

5 40) A local restaurant owner is considering expanding into another urban area. The expansion project will be financed through a line of credit with First National Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy an existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include: A) $500 administrative costs, $2,500 per month rent. B) $1,000 per month interest payments, $2,500 per month rent. C) $2,500 per month rent. D) $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent. 40) 41) Margo Inc. wants to replace a 7-year-old machine with a new machine that is more efficient. The old machine cost $50,000 when new and has a current book value of $10,000. Margo can sell the machine to a foreign buyer for $12,000. Margo's tax rate is 30%. The effect of the sale of the old machine on the initial outlay for the new machine is: A) ($11,400). B) $0. C) ($8,400). D) ($12,600). 42) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the initial outlay required to fund this project? A) $77,500 B) $75,000 C) $74,500 D) $62,500 43) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the incremental free cash flow for the first year of the project? A) $22,800 B) $24,750 C) $30,880 D) $28,400 41) 42) 43) 5

6 44) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the terminal cash flow for this project? A) $10,200 B) ($4,200) C) $21,000 D) $17,400 44) 45) A new project is expected to generate $600,000 in revenues, $200,000 in cash operating expenses, and depreciation expense of $100,000 in each year of its 10-year life. The corporation's tax rate is 40%. The project will require an increase in net working capital of $75,000 in year one and a decrease in net working capital of $50,000 in year ten. What is the free cash flow from the project in year one? A) $355,000 B) $105,000 C) $280,000 D) $205,000 46) Jones Company expects the following results in year one of a new project: 45) 46) Revenue $300,000 Cash Expenses 100,000 Depreciation 80,000 EBIT $120,000 Taxes 40,800 Net Income $79,200 The annual change in operating cash flow is equal to: A) $147,200. B) $159,200. C) $200,000. D) $80, ) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the incremental free cash flow for year one? A) $18,850 B) $22,250 C) $21,305 D) $19,900 47) 6

7 48) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the terminal cash flow? A) $18,000 B) $12,750 C) $9,750 D) $23,250 49) The recapture of net working capital at the end of a project will 49) A) decrease terminal year free cash flow by the change in net working capital times the corporate tax rate. B) increase terminal year free cash flow. C) increase terminal year free cash flow by the change in net working capital times the corporate tax rate. D) have no effect on the terminal year free cash flow because the net working capital change has already been included in a prior year. 48) 50) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of a synergistic effect from the new diagnostic testing procedure is the: A) increase in revenue of $10,000 per month for the diagnostic testing. B) increase in all activities totaling $19,000 per month. C) increase in revenues from oil changes and brake jobs of $4,000 per month. D) increase in inventory levels of oil and brake parts. 51) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of an increase in net working capital requirements from the new diagnostic testing procedure is the: A) increase in revenues from oil changes and brake jobs of $4,000 per month. B) increase in inventory levels of oil and brake parts of $5,000. C) increase in all activities totaling $19,000 per month. D) increase in revenue of $10,000 per month for the diagnostic testing. 50) 51) 7

8 52) If depreciation expense in year one of a project increases for a highly profitable company, 52) A) net income increases and incremental free cash flow increases. B) net income decreases and incremental free cash flow decreases. C) net income decreases and incremental free cash flow increases. D) the book value of the depreciating asset increases at the end of year one. 53) Salvage value would most likely not be considered by 53) A) internal rate of return. B) net present value. C) payback. D) A and B. 54) Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal? A) cost of issuing new bonds if the project is financed by a new bond issue B) installation costs C) increase in accounts receivable D) none of the above - all are considered 54) 55) Which of the following is NOT considered in the calculation of incremental cash flows? 55) A) tax saving due to increased depreciation expense B) interest payments if new debt is issued C) increased dividend payments if additional preferred stock is issued D) B and C 56) A project for Jevon and Aaron, Inc. results in additional accounts receivable of $200,000, additional inventory of $120,000, and additional accounts payable of $50,000. What is the additional investment in net working capital? A) $30,000 B) $370,000 C) $270,000 D) $130,000 57) Project XYZ requires an investment in equipment of $500,000 to replace existing equipment. The existing equipment will produce after-tax salvage value of $50,000. Net working capital requirements are increased by $50,000. What is the total cash outflow at time zero? A) $400,000 B) $550,000 C) $500,000 D) $600,000 E) $450,000 58) A five-year project for East Nile, Inc. results in additional accounts receivable of $120,000, additional inventory of $30,000, and additional accounts payable of $70,000 today. What is the change in the NPV of a project solely due to the additional net working capital (NWC) needs. Assume a 12% discount rate, and the typical expected recovery of the NWC investment. A) a decrease of $34,606 B) a decrease of $138,423 C) a decrease of $45,395 D) a decrease of $181,577 56) 57) 58) 8

9 59) Which of the following should be included in the initial outlay? 59) A) taxable gain on the sale of old equipment being replaced B) increased investment in inventory and accounts receivable C) preexisting firm overhead reallocated to the new project D) first year depreciation expense on any new equipment purchased 60) Increased depreciation expenses affect tax-related cash flows by 60) A) decreasing taxable income, with no effect on cash flow since depreciation is a non-cash expense. B) increasing taxable income, thus increasing taxes. C) pushing a corporation into a higher tax bracket. D) decreasing taxable income, thus reducing taxes. 61) Which of the following are included in the terminal cash flow? 61) A) any tax payments or receipts associated with the salvage value of the asset B) recapture of any working capital increase included in the initial outlay C) the expected salvage value of the asset D) all of the above 62) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. What will depreciation expense be during the first year? A) $7,500 B) $8,500 C) $8,700 D) $8,100 63) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. J.B. is replacing an old machine that was purchased 7 years ago for $50,000. The old machine was being depreciated on a straight-line basis over a ten year expected useful life. The machine was sold for $10,000. J.B.'s marginal tax rate is 40%. What is the amount of the initial outlay? A) $81,000 B) $85,000 C) $77,000 D) $75,000 64) When terminating a project for capital budgeting purposes, the working capital outlay required at the initiation of the project will A) increase the cash flow because it is recaptured. B) decrease the cash flow because it is a historical cost. C) decrease the cash flow because it is an outlay. D) not affect the cash flow. 62) 63) 64) 9

10 65) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. Which of the following statements concerning the change in working capital is most accurate? A) The $2,000 paid for oil is added to the initial outlay, offset by the tax savings $800. B) The $2,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR. C) The $2,000 may be expensed each year over the life of the project as part of the incremental free cash flows. D) Even if the $2,000 is fully recovered at the end of the project, the project's NPV and IRR will be lower if the change in working capital is included in the analysis. 65) 66) XYZ company is considering replacing an old machine with a new one. Two months ago their chief engineer completed a training seminar on the new machine's operation and efficiency. The $4,000 cost for this training session has already been paid. If the new machine is purchased, it would require $5,000 in installation and modification costs to make it suitable for operation in the factory. The old machine originally cost $90,000 five years ago and is being depreciated by $15,000 per year. The new machine will cost $80,000 before installation and modification. It will be depreciated by $5,000 per year. The old machine can be sold today for $10,000. The marginal tax rate for the firm is 40%. Compute the relevant initial outlay in this capital budgeting decision. A) $73,000 B) $77,000 C) $72,500 D) $84,000 67) Brooke Burke Corporation is considering a new product line. The company currently manufactures several lines of snow skiing apparel. The new products, insulated ski bikinis, are expected to generate sales of $1 million per year for the next five years. They expect that during this five-year period, they will lose about $250,000 in sales on their existing lines of longer ski pants. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products. The new project will, however, require that the company spend an additional $80,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year in salary and benefits. Because of the different construction of the bikinis, an increase in inventory of $3,800 would be required initially. If the marginal tax rate is 30%, compute the incremental after tax cash flows for years 1-5. A) $437,500 per year B) $434,500 per year C) $187,500 per year D) $625,000 per year 68) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The initial outlay for the new machine is: A) $109,800. B) $112,200. C) $113,000. D) $111, ) 67) 68) 10

11 69) The financial manager selecting one of two projects of differing risk should: 69) A) choose the project with greater return even if that project has greater risk. B) select the project with the larger risk-adjusted net present value. C) choose the project with less risk even though that project has less return. D) choose the project with the least relative risk. 70) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the incremental free cash flow during year 1 of the project? A) $12,800 B) $11,400 C) $14,400 D) $15,200 70) 71) Incremental cash flows refer to: 71) A) The difference between after-tax cash flows and before-tax accounting profits. B) The cash flows of a project, minus financing costs. C) The new cash flows that will be generated if a project is undertaken. D) The cash flows that are foregone if a firm does not undertake a project. 72) Which of the following should be included in an analysis of a new project's cash flows? 72) A) All sunk costs. B) No opportunity costs. C) All financing costs. D) Any sales from existing products that would be lost if customers were expected to purchase a new product instead. 73) It is important to consider a new project's affect on the cash flows of existing projects because of: 73) A) synergy. B) cannibalism. C) sunk costs. D) A and B above. 74) Which of the following should be excluded in an analysis of a new project's cash flows? 74) A) Additional interest expenses on debt financing B) Additional investment in inventory C) Additional investment in fixed assets D) Additional investment in accounts receivable 11

12 75) Which of the following expenses associated with a project should not be included in a capital budgeting analysis? A) Reengineering of a production line associated with a new project B) Additional maintenance expenses associated with new equipment C) Training sales staff on a new product D) Additional allocated fixed overhead from corporate headquarters 75) 76) A new machine can be purchased for $1,000,000. It will cost $65,000 to ship and $35,000 to modify the machine. A $30,000 recently completed feasibility study indicated that the firm can employ an existing factory owned by the firm, which would have otherwise been sold for $150,000. The firm will borrow $750,000 to finance the acquisition. Total interest expense for 5-years is expected to approximate $250,000. What is the investment cost of the machine for capital budgeting purposes? A) $1,280,000 B) $2,030,000 C) $1,530,000 D) $1,250,000 E) $1,100,000 77) Zinc, Inc. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. Studies have shown that employee-training expenses will be $125,000. What is the total investment in the processing line for capital budgeting purposes? A) $4,125,250 B) $3,980,000 C) $4,190,250 D) $3,875,000 76) 77) 78) Which of the following should not be included as investment costs in evaluating a capital asset? 78) A) Shipping expenses B) Installation expenses C) Employee training expenses D) Interest payments and other financing cash flows that result from raising funds to finance a project 79) A new machine can be purchased for $1,500,000. It will cost $45,000 to ship and $55,000 to fine-tune the machine. The new machine will replace an older version that is fully depreciated and will be sold for $125,000. The firm's income tax rate is 40%. What is the initial outlay for capital budgeting purposes? A) $1,525,000 B) $1,725,000 C) $1,675,000 D) $1,600,000 80) Blue Jay Industries is considering the purchase of a new machine. It will replace an existing but obsolete machine that will be sold for $40,000. The existing machine is 8 years old, cost $150,000, had a 10-year useful life, and is being depreciated to zero using the straight-line method. Blue Jay's income tax rate is 40%. What is the after-tax salvage value of the old machine? A) $6,000 B) $36,000 C) $24,000 D) $40,000 79) 80) 12

13 81) Zinc, Inc. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000; it will have a 10-year useful life. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. The processor will be depreciated using the straight-line method to zero expected salvage value. Studies have shown that employee-training expenses will be $125,000. What will be the annual depreciation expense of the processing line for capital budgeting purposes? A) $419,025 B) $400,025 C) $390,000 D) $375,000 81) 82) Nickel Industries is considering the purchase of a new machine that will cost $178,000, plus an additional $12,000 to ship and install. The new machine will have a 5-year useful life and will be depreciated using the straight-line method. The machine is expected to generate new sales of $85,000 per year and is expected to increase operating costs by $10,000 annually. Nickel's income tax rate is 40%. What is the projected incremental cash flow of the machine for year 1? A) $66,350 B) $60,200 C) $54,800 D) $68,200 83) Crighton Industries is considering the purchase of a new machine that will cost $250,000, plus an additional $10,000 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to have a salvage value of $30,000 at the end of year five. Crighton's income tax rate is 40%. The additional net working capital from this project of $50,000 is expected to return to its pre-project level upon termination. What is the non-operating terminal cash flow of the machine? A) -$32,000 B) $80,000 C) $68,000 D) $48,000 84) Creighton Industries is considering the purchase of a new strapping machine, which will cost $120,000, plus an additional $7,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $25,000 per year and is expected to save $17,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $30,000. Creighton's income tax rate is 40%. What is the machine's IRR? A) 13.5% B) 12.0% C) 15.0% D) 18.3% 85) A company is expanding and has already signed a lease on new office space that costs $10,000 per month. The company also needs a new information system and hired a consultant to recommend new software. The consultant was paid $5,000 for her recommendation. Now the company is trying to make a choice between three competing software products. In the capital budgeting decision to purchase new software, the monthly rent for the office space is and the consultant's fee is. A) an opportunity cost, a sunk cost B) a sunk cost, a part of the initial outlay C) a sunk cost, a sunk cost D) incremental cash outflow, an opportunity cost 82) 83) 84) 85) 13

14 86) As part of its expansion project, A.J. Industries Equipment Division has expanded its office space by 200 square feet. The company's administrative overhead is allocated based on the square footage of each business segment. Although the total administrative overhead for the company will remain the same, the Equipment Division will be charged more for administrative overhead. For the Equipment Division expansion project, the administrative overhead is an example of a(n) A) incremental cash flow. B) opportunity cost. C) incremental opportunity cash flow. D) sunk cost. 86) 87) An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project. The company has a tax rate of 30%. This transaction will have what impact on the project's initial outlay? A) reduce it by $20,000 B) reduce it by $6,000 C) reduce it by $15,000 D) reduce it by $50,000 88) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the incremental free cash flow during years 2 through 10 of the project? A) $14,400 B) $15,800 C) $13,600 D) $16,400 89) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the project's terminal cash flow? A) $3,000 B) $8,000 C) $5,000 D) $6,000 87) 88) 89) 14

15 90) Ames Manufacturing is considering the purchase of new, sophisticated machinery for a special three-year project. The machinery requires a special lubricating oil that probably will never be used, but must be available at all times should the machine break down. Ames purchases $2,000 of lubricating oil to keep on hand just in case it is needed. At the end of the three-year project, it is expected the lubricating oil can be sold back to the distributor for $2,000. Which of the following statements is most correct? A) The $2,000 for lubricating oil is simply an accounting entry and does not represent a real cash flow. B) The $2,000 represents an additional investment in working capital that should be included in the capital budgeting analysis. C) The $2,000 for the lubricating oil should be excluded from the analysis because it is recovered at the end of three years, so the final cost is zero. D) The lubricating oil is a sunk cost that should be excluded from the analysis. 90) 91) A major corporation is considering a capital budgeting project that involves the development of a new technology. The controller estimates the net present value to be negative, yet argues that the company should invest in the project. Which of the following statements is most correct? A) Capital rationing may exist for the current year. B) The profitability index may be greater than one, giving an accept decision. C) The controller should be fired for making such a poor decision. D) The controller may be considering the option to expand or modify the project in the future. 92) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine? A) a savings of $3,500 B) a tax savings of $1,200 C) a savings of $1,750 D) additional taxes paid of $1,750 93) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the initial outlay required to fund this replacement project? A) $78,500 B) $81,500 C) $74,500 D) $71,500 91) 92) 93) 15

16 TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 94) A small, family-owned corporation would be more likely to use the contribution-to-firm risk criteria rather than the systematic risk to evaluate capital budgeting projects. 95) Since stockholders are able to reduce their exposure to risk by efficiently diversifying their holdings of securities, there is no reason for individual firms to seek diversification of their holdings of assets. 94) 95) 96) According to the CAPM, systematic risk is the only relevant risk for capital budgeting purposes. 96) 97) A project's contribution-to-firm risk does allow for diversification within the firm. 97) 98) A project's standing alone risk allows for diversification within a sole firm. 98) MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 99) A wildcat oil driller has enough capital to invest in only one project, that is, to drill one well in an East Texas oil field. A major oil company is drilling 100 wells in the same field. The probability of successfully striking oil is 10% for any well drilled in this field. Which of the following statements is most correct concerning the risk involved in these capital budgeting projects? A) The risk for the wildcat driller is the same as the risk for the major oil company since they are both drilling in the same oilfield. B) The best measure of risk for the wildcat oil driller is project standing alone risk. C) The appropriate risk for the wildcat driller is systematic risk. D) The appropriate risk for the major oil company is contribution-to-firm risk, if all shareholders of the firm are well diversified. 100) Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net worth. When considering capital budgeting projects for their boutiques, the appropriate measure of risk is A) Beta risk. B) Project standing alone risk. C) Systematic risk. D) Contribution-to-firm risk. 101) If bankruptcy costs and/or shareholder underdiversification are an issue, what measure of risk is relevant when evaluating project risk in capital budgeting? A) Contribution-to-firm risk B) Capital rationing risk C) Systematic risk D) Total project risk 99) 100) 101) 102) Which of the following is the most relevant measure of risk for capital budgeting purposes? 102) A) Contribution-to-firm risk B) Unsystematic risk C) Project standing alone risk D) Symbiotic risk 16

17 103) Which of the following statements about project standing alone risk is true? 103) A) It provides the best measure of project risk for a large, widely-held company. B) It ignores the cash flows that are associated with a project that occur beyond the payback period. C) It takes into consideration the effects of diversification of the firm's shareholders. D) It ignores the fact that much of the risk of a project will be diversified away as the project is combined with the firm's other projects. TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 104) Interest expenses are not included as incremental free cash flows because the cost of funds is recognized as cash flows are discounted back to present value. 105) The use of risk-adjusted discount rates is based on the concept that investors require a higher rate of return for more risky projects. 106) The risk-adjusted discount rate method implicitly assumes that distant cash flows have the same risk as near cash flows. 107) If the cash flows of an accepted investment project are negatively correlated with the average cash flow of the firm's existing assets, then the company's total exposure to risk can decrease. 104) 105) 106) 107) 108) Financial theory assumes that individuals are risk averse. 108) 109) The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same firm when considering a new product line. 109) 110) The less-risky investment is always the more desirable choice. 110) 17

18 MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 111) A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven, and another capital budgeting project involving research and development into synthetic food substitutes. Which of the following statements is most correct concerning the risk-adjusted discount rate(s) for the projects? A) The rate should be the same for both projects because they are being considered by one company with the same common shareholders. B) The rate will likely be higher for the research and development project because of the uncertainty involved with research and development projects. C) The rate should be higher for the replacement project because the company is more certain of the returns from a project similar to their existing business. D) The rate will likely be higher for the replacement project because the likelihood of success is higher. 111) 112) The pure play method: 112) A) selects a firm similar to the project being analyzed and uses its returns as the market return in estimating a project beta. B) selects one of the firm's existing projects that is similar to the project being analyzed and uses that project's required rate of return. C) calculates beta using only project returns. D) uses the beta of a firm that is similar to the project being analyzed to determine the required rate of return for the project. 113) Which of the following is NOT an important consideration in measuring risk for a capital budgeting project for a well-diversified firm? A) Systematic risk B) Total project risk C) Contribution to firm risk D) None of the above - all may be important in measuring project risk 114) Humongous Corporation is a multidivisional conglomerate. The Food Division is undergoing a capital budgeting analysis and must estimate the division's beta. This division has a different level of systematic risk than is typical for Humungous Corporation as a whole. The most appropriate method for estimating this beta is. A) The regression coefficient from a time series regression of Food Division's return on assets on a market index B) To multiply the company's beta by the ratio of the Food Division's total assets/humungous Corporation total assets C) The regression coefficient from a time series regression of Food Division's net income on the Humungous Corporation's return on assets D) The regression coefficient from a time series regression of Humungous Corporation stock returns on a market index 113) 114) 18

19 115) One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project. This method is referred to as. A) the pure play method B) sensitivity analysis C) the accounting beta method D) scenario analysis 115) 116) Creighton Industries is considering the purchase of a new strapping machine, which will cost $120,000, plus an additional $7,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $25,000 per year and is expected to save $17,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $30,000. Creighton uses a 13.5% discount rate for capital budgeting purposes and the firm's income tax rate is 40%. What is the machine's NPV? A) $8,888 B) $25,000 C) $12,153 D) $5, ) TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 117) Sensitivity analysis involves changing one variable at a time. 117) 118) A typical decision rule used in simulation is to accept the project if the probability is sufficiently high that the net present value is positive. 118) 119) Reducing the probability of bankruptcy is a benefit of diversification. 119) 120) Using simulation provides the financial manager with a probability distribution of an investment's net present value or internal rate of return. 120) MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 121) Advantages of using simulation include: 121) A) a range of possible outcomes presented. B) is good only for single period investments since discounting is not possible. C) graphically displays all possible outcomes of the investment. D) adjustment for risk in the resulting distribution of net present values. 122) What method is used for calculation of the accounting beta? 122) A) regression analysis B) sensitivity analysis C) simulation D) both A and C 19

20 123) The simulation approach provides us with: 123) A) a probability distribution of the project's net present value or internal rate of return. B) a graphic exposition of the year-by-year sequence of possible outcomes. C) an approximation of the systematic risk level. D) a single value for the risk-adjusted net present value. 124) Which of the following is not an acceptable method of measuring risk for capital budgeting purposes? A) Modified internal rate of return B) Proxy, or pure play method for estimating a project's beta C) Using a risk-adjusted discount rate D) Sensitivity analysis 124) TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 125) Fluctuating currency exchange rates should be ignored in capital budgeting because for a U.S. firm, all incremental cash flows will be properly measured in dollars. 125) 20