Keown Tif 10 FINAL

Chapter 10
Cash Flow and Other Topics in Capital Budgeting
True/False
1. Because installment costs of a new asset are a current cash expense, they are excluded from the initial
outlay.
ANSWER: False
DIFFICULTY: Moderate
KEYWORDS: initial outlay
2. When an old asset is sold for exactly its depreciated value, the only taxable income is the difference
between the initial cost of the machine and the selling price.
ANSWER: False
KEYWORDS: selling old asset
3. The capital rationing problem can be correctly solved by ranking projects according to the profitability
index.
ANSWER: False
KEYWORDS: capital rationing
4. The capital budgeting decision-making process involves measuring the incremental cash flows of an
investment proposal and evaluating the attractiveness of these cash flows relative to the project’s cost.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: capital budgeting decision process
5. Working capital for a project includes investment in fixed assets.

ANSWER: False
DIFFICULTY: Easy
KEYWORDS: working capital
6. The initial outlay involves the immediate cash outflow necessary to purchase the asset and put it in
operating order.
ANSWER: True
7. When replacing an existing asset, the cash inflow associated with the sale of the old asset and any
related tax effects must be considered and accounted for in the analysis.
ANSWER: True
KEYWORDS: replacing asset cash flows
8. In measuring cash flows we are interested only in the incremental or differential after-tax cash flows
that are attributed to the investment proposal being evaluated.
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ANSWER: True
KEYWORDS: incremental cash flows
9. Cash flows associated with a project’s termination generally include the salvage value of the project
plus or minus any taxable gains or losses associated with its sale.
ANSWER: True
KEYWORDS: terminal cash flows
10. Since depreciation is a sunk cost, it is not necessary to consider depreciation in estimating cash flows for a
new capital project.
ANSWER: False
KEYWORDS: depreciation expense, sunk cost
11. Projects are said to be mutually exclusive when undertaking one prevents doing the other(s).
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: mutually exclusive
12. The initial outlay of an asset does not include installation costs.
ANSWER: False
13. Additional cash needed to fill increased working capital requirements should be included in the initial
cost of a product when analyzing an investment.
ANSWER: True
KEYWORDS: working capital requirements
14. To be conservative, capital budgeting analysis assumes that projects cannot add sales to existing lines
of business.
ANSWER: False
KEYWORDS: incremental sales, existing lines of business
15. In making a capital budgeting decision we only include the incremental cash flows resulting from the
investment decision.
ANSWER: True
16. By examining cash flows, we are correctly able to analyze the timing of the benefits.
ANSWER: True
KEYWORDS: timing of cash flows
17. The opportunity cost of using a resource in some way is the amount the resource could earn if used in
an alternative way.
ANSWER: True
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KEYWORDS: opportunity cost
18. If the firm decides to impose a capital constraint on investment projects, the appropriate decision
criterion is to select the set of projects that has the highest net present value subject to the capital
constraint.
ANSWER: True
19. The size disparity problem occurs when extremely large mutually exclusive projects are being
examined.
ANSWER: False
KEYWORDS: mutually exclusive projects
20. Capital rationing can occur when profitable projects must be rejected because of shortage of capital.
ANSWER: True
21. A financial manager had his choice between two mutually exclusive investments, one with a
distribution skewed to the right and one with a distribution skewed to the left. Both distributions have
the same expected value and same standard deviation. The financial manager would prefer the one
skewed to the left.
ANSWER: False
22. A project’s equivalent annual annuity (EAA) is calculated by dividing the project’s NPV by the
PVIFAi,n where i is the appropriate discount rate and n is the project’s life.
ANSWER: True
KEYWORDS: equivalent annual annuity
23. A project’s equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value
as the project’s NPV.
ANSWER: True
24. An infinite life replacement chain allows projects of different length lives to be compared.
ANSWER: True
KEYWORDS: infinite replacement chain
25. In selecting projects when there is capital rationing, the payback period method should be used.
ANSWER: False
26. Accounting profits represents free cash flows that are available for reinvestment.
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ANSWER: False
DIFFICULTY: Easy
KEYWORDS: accounting profits, free cash flows
27. Working capital requirements are considered a cash flow even though they do not leave the company.
ANSWER: True
KEYWORDS: working capital requirements
28. Sunk costs are a type of incremental cash flow that should be included in all capital-budgeting
decisions.
ANSWER: False
KEYWORDS: sunk costs
29. The pertinent issue for determining whether overhead costs should be part of a project’s relevant after-
tax cash flow is whether the project benefits from the overhead items.
ANSWER: False
KEYWORDS: overhead
30. The hardest step in capital budgeting analysis is calculating the cash flows of a project.
ANSWER: True
KEYWORDS: cash flow calculations
31. Since depreciation is a non-cash expense, it should not be included as part of a project’s relevant after-
tax cash flow.
ANSWER: False
KEYWORDS: depreciation expense
32. A marketing survey completed last year to determine a project’s feasibility would be included as part of
the project’s initial cash outflow.
ANSWER: False
KEYWORDS: relevant cash flows, sunk costs
33. Expenses incurred to install an asset are part of the asset’s initial cash outflow.
ANSWER: True
34. Sales captured from the firm’s competitors can be relevant to the capital-budgeting decision.
ANSWER: True
KEYWORDS: lost sales
35. Any capital rationing that rejects projects with positive net present values is contrary to the firm’s goal
of shareholder wealth maximization.
ANSWER: True
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36. NPV and IRR can provide ranking inconsistencies when projects have unequal lives.
ANSWER: True
KEYWORDS: project ranking
Multiple Choice
37. Incremental cash flows include all of the following EXCEPT:

a. labor and material savings.
b. sunk costs.
c. interest to bondholders.
d. both b & c.
ANSWER: a
DIFFICULTY: Easy
38. The net present value always provides the correct decision provided that:
a. cash flows are constant over the asset’s life.
b. the required rate of return is greater than the internal rate of return.
c. capital rationing is not imposed.
d. the internal rate of return is positive.
ANSWER: c
KEYWORDS: capital rationing and NPV
39. If the federal income tax rate were increased, the result would be an increase in the:
a. discounted payback period.
b. internal rate of return.
c. net present value.
d. profitability index.
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: discounted payback period, taxes
40. Which of the following techniques may not consider ALL cash flows of a project?
a. Net present value
b. Internal rate of return
c. Payback period
d. Modified internal rate of return
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: payback period
41. Which of the following cash flows are not considered in the calculation of the initial outlay for a capital
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investment proposal?
a. Training expense
b. Working capital investments
c. Installation costs of an asset
d. Before-tax selling price of old machine
ANSWER: d
42. Which of the following is not considered in the calculation of incremental cash flows?
a. Depreciation tax shield
b. Sunk costs
c. Opportunity costs
d. Both a & b
ANSWER: b
43. If the federal income tax rate were increased, the impact of the tax increase on acceptable investment
proposals would be to (ignore the impact of the tax change on the cost of capital) decrease the:
a. net present value.
c. payback period.
d. both a & b.
e. all of the above.
ANSWER: d
44. Which of the following would increase the net working capital for a project? An increase in:
a. accounts receivable.
b. fixed assets.
c. accounts payable.
d. common stock.
ANSWER: a
KEYWORDS: net working capital
45. Which of the following should be included in the initial outlay?

a. Shipping and installation costs
b. Increased working capital requirements
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c. Cost of employee training associated specifically with the asset being evaluated
d. All of the above
ANSWER: d
46. Depreciation expenses affect capital budgeting analysis by increasing

a. taxes paid.
b. incremental cash flows.
c. the initial outlay.
d. working capital.
ANSWER: b
DIFFICULTY: Easy
KEYWORDS: incremental cash flows, depreciation expense
47. Which of the following is included in the terminal cash flow?

a. The expected salvage value of the asset
b. Tax impacts from selling asset
c. Recapture of any working capital
d. All of the above
ANSWER: d
DIFFICULTY: Easy
KEYWORDS: terminal cash flow
48. A firm purchased an asset with a 5-year life for $90,000, and it cost $10,000 for shipping and
installation. According to the current tax laws the cost basis of the asset is:
a. $100,000.
b. $95,000.
c. $80,000.
d. $70,000.
ANSWER: a
DIFFICULTY: Easy
KEYWORDS: cost basis of asset, initial outlay
49. XYZ, Inc. is considering adding a product line that would utilize unused floor place of their
manufacturing plant. The floor space would be considered a(n):
a. variable cost.
b. opportunity cost.
c. sunk cost.
d. irrelevant cash flow.
ANSWER: b
50. Which of the following is included in the calculation of the initial outlay for a capital investment?
a. Investment in working capital
b. Shipping expenses
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c. Installation
d. All of the above
ANSWER: d
51. Which of the following would decrease free cash flows? A decrease in:
a. depreciation expense.
b. interest expense.
c. incremental sales.
d. both a & c.
e. all of the above.
ANSWER: c
KEYWORDS: free cash flows
52. Your company is considering replacing an old steel cutting machine with a new one. Two months ago,
you sent the company engineer to a training seminar demonstrating the new machine’s operation and
efficiency. The $2,500 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 your factory. The old machine originally cost $50,000 five years ago and is being
depreciated by $7,000 per year. The new machine will cost $75,000 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. $72,500
b. $68,000
c. $70,500
d. $78,000
ANSWER: b
DIFFICULTY: Hard
53. Burr Habit Corporation is considering a new product line. The company currently manufactures several
lines of snow skiing apparel. The new products, insulated ski shorts, are expected to generate sales less
cost of goods sold of $1 million per year for the next five years. They expect that during this five year
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period, they will lose about $250,000 per year in sales less cost of goods sold on their existing lines of
longer ski pants as a result of the introduction of the new product line. The new line will require no
additional equipment or space in the plant and can be produced in the same manner as the existing
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 shorts, 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 year 1-5.
a. $434,500 per year
b. $625,000 per year
c. $187,500 per year
d. $437,500 per year
ANSWER: d
DIFFICULTY: Hard
KEYWORDS: incremental cash flow
54. Al’s Fabrication Shop is purchasing a new rivet machine to replace an existing one. The new machine
costs $8,000 and will require an additional cost of $1,000 for modification and training. It will be
depreciated using simplified straight line depreciation over five years. The new machine operates much
faster than the old machine and with better quality. Consequently, sales are expected to increase by
$2,100 per year for the next five years. While it is faster, it is fully automated and will result in
increased electricity costs for the firm by $700 per year. It will, however, save about $850 per year in
labor costs. The old machine is 20 years old and has already been fully depreciated. If the firm’s
marginal tax rate is 28%, compute the after tax incremental cash flows for the new machine for years 1
through 5.
a. $2,698
b. $450
c. $2,124
d. $1,620
ANSWER: c
DIFFICULT: Hard
55. National Geographic is replacing an old printing press with a new one. The old press is being sold for
$350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40%
income tax bracket. How much will National Geographic pay in income taxes from the sale?
a. $140,000
b. $45,000
c. $110,000
d. $87,010
ANSWER: c
KEYWORDS: tax on sale of asset
56. National Geographic is replacing an old printing press with a new one. The old press is being sold for
$350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40%
income tax bracket. How much will National Geographic net from the sale?
a. $315,000
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b. $112,112
c. $240,000
d. $116,050
ANSWER: c
KEYWORDS: sale of asset
57. Crawfish Kitchen Inc. is planning to invest in one of three mutually exclusive projects. Projected cash
flows for these ventures are as follows:
Which project is the most profitable according to the NPV Criteria if the discount rate for the firm is
14%?
a. Plan A
b. Plan B
c. Plan C
ANSWER: c
58. What is the capital budgeting term that is used to refer to more than one investment alternative that
performs the same function?
a. Simulated
b. Capital rationed
c. Mutually exclusive
d. Opportunistic
ANSWER: c
59. Which of the following income or expense items should be rejected when estimating cash flows for
investment projects?
a. Incremental sales
b. Opportunity costs
c. Financing costs
d. Operating expenses
ANSWER: c
KEYWORDS: financing costs
60. Which of the following expenses should be included when estimating cash flows for investment
projects?
a. Interest expense related to financing a project
b. Sunk costs
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c. Required principal payments related to financing a project
d. Opportunity costs
ANSWER: d
KEYWORDS: opportunity costs
61. Capital rationing may be imposed because:

a. capital market conditions are poor.
b. of management’s fear of debt.
c. stockholder control problems prevent issuance of additional stock.
d. all of the above.
ANSWER: d
62. When selecting the best project from a group of mutually exclusive projects you should choose the
project with the highest:
c. accounting rate of return.
d. payback.
ANSWER: a
63. The most common method of solving the unequal life problem is:
a. to create a replacement chain to equalize the life span.
b. to assume that the cash inflows from the shorter-lived investment will be reinvested at the cost of
capital until the termination of the longer-lived investment.
c. to project future cash flows from reinvestment opportunities in the future from the cash flows
generated by the shorter-lived investment.
d. none of the above.
ANSWER: a
KEYWORDS: unequal lives
64. If a company decides that it needs to impose capital rationing, which statement is true?
a. The effect is positive if adverse economic conditions exist.
b. The effect is positive if there is a shortage of effective managers within the firm to manage the
project.
c. The effect is negative because the process involves rejecting a project with a positive net present
value, which in turn fails to maximize shareholders’ wealth.
d. The effect is negative because it results from a manager’s fear of risk.
ANSWER: c
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65. You are in charge of one division of Bigfella Conglomerate Inc. Your division is subject to capital
rationing. Your division has four indivisible projects available, detailed as follows:
Project Initial Outlay IRR NPV
1 2 million 18% 2,500,000
2 1 million 15% 950,000
3 1 million 10% 600,000
4 3 million 9% 2,000,000
If you must select projects subject to a budget constraint of 5 million dollars, which set of projects
should be accepted so as to maximize firm value?
a. Projects 1, 2, and 3
b. Project 1 only
c. Projects 1 and 4
d. Projects 2, 3, and 4
ANSWER: c
66. Your company is considering an investment in one of two mutually exclusive projects. Project 1
involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after
tax cash flows of $500 per year in years 1-5. Project 2 involves a capital intensive process, requiring an
initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years
1-5. Your firm’s discount rate is 10%. If your company is not subject to capital rationing, which
project(s) should you take on based on the basic capital budgeting criteria (NPV and IRR)?
a. Project 1
b. Project 2
c. Projects 1 and 2
d. Neither project is acceptable.
ANSWER: b
67. Regal Enterprises is considering the purchase of a new embroidering machine. It is expected to
generate additional sales of $400,000 per year. The machine will cost $295,000, plus $3,000 to install
it. The embroiderer will save $12,000 in labor expense each year. Regal is in the 34% income tax
bracket. The machine will be depreciated on a straight-line basis over five years (it has no salvage
value). The embroiderer will require annual operating expenses of $136,000. What is the annual
operating cash flow that the machine will generate?
a. $316,954
b. $124,000
c. $202,424
d. $165,816
ANSWER: c
68. Mr. Smith included the cost of test marketing before production in the calculation of the initial
outlay. Apparently, Mr. Smith does not understand the concept of:
a. side-effect costs.
b. opportunity costs.
c. sunk costs.
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d. variable costs.
ANSWER: c
DIFFICULTY: Easy
69. Your firm is considering investing in one of two mutually exclusive projects. Project A requires an
initial outlay of $2,500 with expected future cash flows of $1,150 per year for the next three years.
Project B requires an initial outlay of $2,500 with expected future cash flows of $1,577 per year for the
next two years. The appropriate discount rate for your firm is 14%, and it is not subject to capital
rationing. Assuming both projects can be replaced with a similar investment at the end of their
respective lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project
B.
a. $170, $197
b. $472, $463
c. $285, $229
d. $528, $568
ANSWER: c
KEYWORDS: replacement chain
70. Determine the dollar value of a three year annuity that would produce the same NPV as the following
project if the appropriate discount rate is 15%, and initial outflow = 0.
Initial Outflow = $1,200
Cash Flow Year 1 = $800
a. $250.38
b. $673.94
c. $146.28
d. $430.82
ANSWER: c
KEYWORDS: equivalent annuity
71. In general, what effect does capital rationing have on firm value?
a. It increases firm value.
b. It decreases firm value.
c. It can increase or decrease firm value.
d. It has no impact on firm value.
ANSWER: b
72. Relevant incremental cash flows include:

a. sales captured from the firm’s competitors.
b. retained sales that would have been lost to new competing products.
c. incremental sales brought to the firm as a whole.
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ANSWER: d
KEYWORDS: relevant cash flows
73. Which of the following is not one of the categories for a project’s relevant after-tax cash flows?
a. Financing flows
b. Initial cash outflow
c. Differential flows over the project’s life
d. Terminal cash flow
ANSWER: a
KEYWORDS: relevant cash flows
74. Which of the following is not part of a project’s initial cash outflow?
a. The asset’s purchase price
b. Funds committed to support increased inventory levels due to expected increased sales if the firm
adopts the project
c. A marketing survey completed last year to determine the project’s feasibility
d. Expenses incurred to install the asset
ANSWER: c
Use the following information to answer questions 75–79. Delta Inc. is considering the purchase of a new
machine which is expected to increase sales by $10,000 in addition to increasing non-depreciation expenses
by $3,000 annually. Due to the sales increase, Delta expects its working capital to increase $1,000 during the
life of the project. Delta will depreciate the machine using the straight-line method over the project’s five year
life to a salvage value of zero. The machine’s purchase price is $20,000. The firm has a marginal tax rate of
34 percent, and its required rate of return is 12 percent.
75. The machine’s initial cash outflow is:

a. $20,000.
b. $21,000.
c. $27,000.
d. $23,000.
ANSWER: b
76. The machine’s incremental after-tax cash inflow is:

a. $6,420.
b. $7,980.
c. $8,620.
d. $5,980.
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ANSWER: d
77. The machine’s after-tax incremental cash flow in year five is:
a. $6,980.
b. $5,980.
c. $7,120.
d. $8,620.
ANSWER: a
78. The machine’s NPV is:

a. $1,556.56.
b. $2,556.56.
c. $1,123.99.
d. $2,123.99.
ANSWER: c
KEYWORDS: net present value
79. The machine’s IRR is:

a. less than 0.
b. greater than 12 percent.
c. less than 12 percent.
d. equal to 12 percent.
ANSWER: b
KEYWORDS: internal rate of return
80. ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The
machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest
$75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is
presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for
$600,000. What is the depreciable cost basis of the machine?
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a. $3,025,000
b. $2,950,000
c. $2,575,000
d. $2,350,000
ANSWER: b
KEYWORDS: depreciable cost basis
81. ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The
machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest
$75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is
presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for
$600,000. What is the total investment amount required for the machine?
a. $3,025,000
b. $2,950,000
c. $2,575,000
d. $2,350,000
ANSWER: a
82. ABC will purchase a machine that will cost $2,575,000. Required modifications will cost $375,000.
ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life
of 7 years; it is presumed to have no salvage value. ABC plans to depreciate the machine by using the
straight-line method. The machine is expected to increase ABC’s sales revenues by $1,890,000 per
year; operating costs excluding depreciation are estimated at $454,600 per year. Assume that the firm’s
tax rate is 40%. What is the annual operating cash flow?
a. $922,464
b. $1,126,287
c. $813,563
d. $1,029,811
ANSWER: d
KEYWORDS: operating cash flow, incremental cash flow
83. ABC purchased a machine for $2,575,000. Required modifications will cost $375,000. ABC will need
to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is
presumed to have no salvage value. It will only be operated for 3 years, after-which it will be sold for
$600,000. ABC plans to depreciate the machine by using the straight-line method. Assume that the
firm’s tax rate is 40%. What is the termination (non-operating) cash flow from the machine in year
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three?
a. $900,623
b. $1,109,286
c. $1,298,114
d. $879,247
ANSWER: b
84. Famous Danish Corp. is replacing an old cookie cutter with a new one. The cookie cutter is being sold
for $25,000 and it has a net book value of $75,000. Assume that Famous Danish is in the 34% income
tax bracket. How much will Famous Danish net from the sale?
a. $61,000
b. $55,000
c. $75,000
d. $42,000
ANSWER: d
KEYWORDS: sale of asset cash flow
Use the following information to answer questions 85-91. A firm is trying to determine whether to replace an
existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The
asset will be depreciated over its five year life using the straight-line method. The new asset is expected to
increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to
the increase in sales, the firm expects an increase in working capital during the asset’s life of $1,500, and the
firm expects to be able to sell the asset for $6,000 at the end of its life. The existing asset was originally
purchased three years ago for $25,000, has a remaining life of five years, and is being depreciated using the
straight-line method. The expected salvage value at the end of the asset’s life (i.e., five years from now) is
$5,000; however, the current sale price of the existing asset is $20,000, and its current book value is $15,625.
The firm’s marginal tax rate is 34 percent and its required rate of return is 12 percent.
85. Increased taxes on the sale of the old machine are:

a. $1,487.50.
b. $2,500.50.
c. $3,823.50.
d. $4,312.50.
ANSWER: a
KEYWORDS: sale of asset cash flow
86. The net initial outlay if the new asset is purchased is:
a. $34,487.50.
b. $54,500.50.
c. $35,987.50.
d. $37,687.50.
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ANSWER: c
87. The incremental change in depreciation is:

a. $9,650.
b. $10,625.
c. $7,475.
d. $8,100.
ANSWER: c
KEYWORDS: incremental depreciation
88. The net incremental after-tax cash flow is:

a. $13,504.00.
b. $13,761.50.
c. $14,824.00.
d. $12,441.50.
ANSWER: d
89. The after-tax terminal cash flow is:

a. $14,601.50.
b. $13,101.50.
c. $13,941.50.
d. $14,941.50.
ANSWER: a
90. The NPV for this replacement decision is:

a. $11,586.97.
b. $10,086.97.
c. $10,735.82.
d. $10,279.89.
ANSWER: b
KEYWORDS: net present value, replacement project
91. The IRR for this replacement decision is:

a. less than zero.
b. equal to 12 percent.
c. less than 12 percent.
d. greater than 12 percent.
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ANSWER: d
KEYWORDS: internal rate of return, replacement project
92. Problems in project ranking can occur due to:

a. size disparity.
b. time disparity.
c. unequal project lives.
ANSWER: d
KEYWORDS: project ranking
Use the following information to answer questions 93-97. You are trying to determine which of two projects
to undertake. Both projects have an initial outlay of $2,000. However, Project Y provides an after-tax cash
flow of $1,000 each year for three years, while Project Z provides an after-tax cash flow of $600 each year for
six years. The required rate of return for both projects is 10 percent. Therefore, Project Y has an NPV of
$486.85 and an IRR of 23.38 percent, and Project Z has an NPV of $613.16 and an IRR of 19.91.
93. The equivalent annual annuity for Project Y is:

a. $186.85.
b. $162.28.
c. $195.76.
d. $111.79.
ANSWER: c
94. The equivalent annual annuity for Project Z is:

a. $204.32.
b. $102.19.
c. $246.55.
d. $140.79.
ANSWER: d
95. The infinite-life replacement chain for Project Y is:

a. $1,957.60.
b. $1,407.90.
c. $1,868.50.
d. $1,673.90.
ANSWER: a
19
KEYWORDS: infinite-life replacement chain
96. The infinite-life replacement chain for Project Z is:

a. $1,957.60.
b. $1,407.90.
c. $1,868.50.
d. $1,657.90.
ANSWER: b
KEYWORDS: infinite-life replacement chain
97. Based on the information, you would:

a. choose Project Z because it has the highest NPV.
b. choose Project Y because it has the highest EAA and infinite-life replacement chain.
c. choose Project Z because it has the highest IRR.
d. choose neither project due to the discrepancy in rankings.
ANSWER: b
KEYWORDS: project selection
98. Which of the following best describes why cash flows are utilized rather than accounting profits when
evaluating capital projects?
a. Cash flows have a greater present value than accounting profits.
b. Cash flows reflect the timing of benefits and costs more accurately than accounting profits.
c. Cash flows are more stable than accounting profits.
d. Cash flows improve the tax position of a firm more than accounting profits.
e. None of the above.
ANSWER: b
KEYWORDS: cash flows
99. Which of the following is the best example of an incremental cash inflow/outflow?
a. Cash flows that are achieved by diverting sales from other projects of the firm
b. Cash flows that are associated with the financing of a project
c. Cash flows that occur a little at a time
d. What the cash flows will be if the project is undertaken as opposed to what they would have been if
the project had not been undertaken
e. None of the above
20
ANSWER: d
KEYWORDS: cash flows
100. Which of the following is an example of a sunk cost?

a. Overhead costs that are associated with a project.
b. Interest expense associated with a project.
c. Market study expenses incurred in order to decide if a firm should accept a project.
d. Income taxes associated with a project.
e. Depreciation expenses associated with a project.
ANSWER: c
KEYWORDS: sunk cost
101. Which of the following cash flows should be included as incremental costs when evaluating capital
projects?
a. Overhead expenses that are directly related to a project.
b. Interest expense that is directly related to the financing of a project.
c. Sunk costs that are related to a project.
d. Principal payments that are directly related to the financing of a project.
ANSWER: a
102. Which of the following cash flows should be included as incremental costs when evaluating capital
projects?
a. Investment in working capital that is directly related to a project
b. Expenses that are incurred in order to modify a firm’s production facility in order to invest in a
project
c. Overhead expenses that are directly related to a project
d. Opportunity costs that are directly related to a project
e. All of the above
ANSWER: e
KEYWORDS: incremental costs
103. How is interest expense that is associated with a project treated in the capital budgeting process?
a. It is treated as a cash outflow when estimating the incremental cash flows associated with a project.
b. It is built into the discount rate.
c. It is considered a synergistic incremental cash flow.
d. Interest expense is not relevant to any capital budgeting decisions.
ANSWER: b
21
KEYWORDS: financing costs
104. The calculation of differential cash flows over a project’s life should include which of the following?
a. Labor and material savings
b. Additional revenues
c. Investment in net working capital
d. All of the above
ANSWER: d
105. Which of the following cash flows are not considered in the calculation of the initial outlay for a capital
investment proposal?
a. Increase in accounts receivable
b. The cost of shipping new equipment
c. The cost of issuing new bonds if the project is financed by a new bond issue
d. The cost of installing new equipment
e. All of the above should be considered.
ANSWER: c
106. Depreciation expenses affect tax-related cash flows by:

a. increasing taxable income, thus increasing taxes.
b. decreasing taxable income, thus reducing taxes.
c. decreasing taxable income, but not altering cash flows since depreciation is not a cash expense.
e. none of the above.
ANSWER: b
KEYWORDS: depreciation expense
107. Which of the following will increase free cash flow?

a. A decrease in interest expense
b. An increase in depreciation expense
c. A decrease in net working capital needs
d. Both a & c
ANSWER: d
KEYWORDS: free cash flow
108. Which of the following would be considered a termination cash flow?

a. The expected salvage value of the asset
b. Any tax payments or refunds associated with the salvage value of the asset
c. Recapture of any investment in working capital that was included as an incremental cash outlay
d. All of the above
22
ANSWER: d
109. The placing of a limit by the firm on the dollar size of the capital budget is referred to as:
a. capital rationing.
b. the reinvestment rate assumption.
c. size disparity.
d. unequal lives.
ANSWER: a
DIFFICULTY: Easy
110. When determining the initial cash outlay of an asset that is being replaced, which of the following
should be included?
a. Interest expense that is directly related to the financing of a project
b. The pre-tax sales proceeds of the asset being sold
c. Market study expenses that were incurred in order to decide if the firm should accept a project
d. Principal payments that are directly related to the financing of a project
e. The sales proceeds of the asset being sold, net of any income taxes related to the sale
ANSWER: e
KEYWORDS: replacement of asset
111. What would cause the initial cash outlay of an investment decision to be affected by the sale of an
existing asset?
a. If the investment decision is a replacement decision
b. If the asset being purchased is technologically superior
c. If the asset being sold has exceeded its MACR’s recovery allowance period
d. All of the above
ANSWER: a
112. Which of the following would cause book profit to differ from cash flow when an investment project is
terminated?
a. Goodwill
b. Recovery of net working capital
c. Income taxes
d. All of the above
ANSWER: b
23
KEYWORDS: net working capital
113. Which of the following should be considered in the estimation of termination cash flows?
a. Cash generated from the sale of a project
b. Recovery of net working capital
c. Income taxes associated with the sale of a project
d. All of the above
ANSWER: d
114. The Board of Directors of Waste Free Chemicals is considering the acquisition of a new chemical
processor. The processor is priced at $600,000 but would require $60,000 in transportation costs and
$40,000 for installation. The processor will have a useful life of 10 years. The project will require
Waste Free to increase its investment in accounts receivable by $80,000 and will also require an
additional investment in inventory of $150,000. The firm’s marginal tax rate is 40 percent. How much
is the initial cash outlay of the processor?
a. $700,000
b. $850,000
c. $930,000
d. $1,040,000
ANSWER: c
115. The Director of Capital Budgeting of Capital Assets Corp. is considering the acquisition of a new high
speed photocopy machine. The photocopy machine is priced at $85,000 and would require $2,000 in
transportation costs and $4,000 for installation. The equipment will have a useful life of 5 years. The
proposal will require that Capital Assets Corp. send technician for training at a cost of $5,000. The
firm’s marginal tax rate is 40 percent. How much is the initial cash outlay of the photocopy machine?
a. $58,600
b. $64,000
c. $77,000
d. $81,000
24
e. $96,000
ANSWER: e
116. Jefferson Corporation is considering an expansion project. The necessary equipment could be
purchased for $15 million and shipping and installation costs are another $500,000. The project will
also require an initial $2 million investment in net working capital. The company’s tax rate is 40%.
What is the project’s initial investment outlay (in millions)?
a. $15.0
b. $15.5
c. $16.5
d. $17.0
e. $17.5
ANSWER: e
117. Wright’s Warehouse has the following projections for Year 1 of a capital budgeting project.
Year 1 Incremental Projections:
Sales $200,000
Variable Costs $120,000
Fixed Costs $40,000
Depreciation Expense $20,000
Tax Rate 40%
Calculate the operating cash flow for Year 1.
a. $12,000
b. $32,000
c. $52,000
d. $72,000
ANSWER: b
DIFFICULTY: Hard
KEYWORDS: operating cash flow
118. SpaceTech is considering a new project with the following projections for Year 2.
Year 2 Projections
EBIT $400,000
Interest Expense $20,000
Depreciation Expense $40,000
Tax Rate 40%
Net Working Capital Needs $200,000
25
If the projected net working capital needs for Year 1 was $150,000, calculate the free cash flow for Year
2.
a. $130,000
b. $180,000
c. $230,000
d. $280,000
ANSWER: c
DIFFICULTY: Hard
KEYWORDS: free cash flow
119. Holding all other variables constant, which of the following will increase the equivalent annual annuity
for a given project? An increase in the:
b. payback Period.
c. discount rate.
d. both a and c.
ANSWER: a
DIFFICULTY: Easy
120. When evaluating Capital Budgeting decisions, which of the following items should not be included in
the construction of cash flow projections for purposes of analysis?
a. Annual sales
b. Fixed expenses
c. Changes in net working capital requirements
d. Sunk costs
e. All of the above should be included
ANSWER: d
121. When evaluating Capital Budgeting decisions, which of the following items should not be included in
the construction of cash flow projections for purposes of analysis?
a. Net salvage value
b. Land and building expenses
c. Changes in net working capital requirements
d. Shipping and installation costs
e. All of the above should be included.
26
ANSWER: e
KEYWORDS: project cash flows
122. Holding all other variables constant, which of the following would INCREASE net working capital for
given year on a project?
a. Allowing customers less time to pay for purchases
b. Taking longer to pay suppliers
c. Increasing inventory levels
d. Both a and c
ANSWER: c
KEYWORDS: net working capital requirements
123. If an investment project would make use of land which the firm currently owns, the project should be
charged with:
a. a sunk cost.
b. an opportunity cost.
c. amortization.
d. interest.
e. abuse of power.
ANSWER: b
124. Which of the following methods allows for the proper comparison of two projects that have entirely
different useful lives?
a. Net present value
b. Equivalent annual annuity
c. Payback
d. Internal rate of return
ANSWER: b
125. Harbor Town Corp. is considering the purchase of a machine. Two alternatives have been isolated. The
firm’s discount rate is 12.5%. Machine A has a net present value of $265,000 and a useful life of 5
years. Machine B has a net present value of $97,500 and a useful life of ears. What is Machine A’s
Equivalent Annual Annuity?
a. $55,821
b. $74,426
c. $37,512
d. $22,318
27
ANSWER: b
126. Harbor Town Corp. is considering the purchase of a machine. Two alternatives have been isolated. The
firm’s discount rate is 12.5%. Machine A has a net present value of $265,000 and a useful life of 5
years. Machine B has a net present value of $97,500 and a useful life of 3 years. What is Machine B’s
Equivalent Annual Annuity?
a. $40,943
b. $55,538
c. $62,826
d. $91,391
ANSWER: a
Short Answer
127. Discuss the reasons that NPV and IRR can lead to different project rankings.
ANSWER: There are three reasons why problems in project ranking can occur. First, comparing
projects of unequal size can lead to different accept/reject decisions between NPV and IRR. Second,
NPV and IRR assume different reinvestment assumptions. NPV assumes cash flows are reinvested at
the cost of capital or required rate of return, whereas IRR assumes reinvestment at the IRR. Last,
comparing projects with unequal lives can cause a conflict.
KEYWORDS: conflicts project ranking
128. Consider the following two projects:
Initial Net Cash flow Each Period

Outlay
1 2 3 4
Project A $4,000 $2,003 $2,003 $2,003 $ 2,003
Project B $4,000 $10,736
Calculate the net present value of each of the above projects, assuming a 14 percent discount rate.
ANSWER:
At a discount rate of 14 percent:
NPVA = $2,003(2.914) - $4,000
NPVA = $1,836.74
NPVB = $10,736(.592) - $4,000
NPVB = $2,355.71
KEYWORDS: project evaluation
129. Consider two mutually exclusive projects X and Y with identical initial outlays of $90,000 and
depreciable lives of 5 years. Project X is expected to produce free cash flows of $32,787 each year.
28
Project Y is expected to generate a single after-tax net cash flow of $223,880 in year 5. The cost of
capital is 15 percent.
a. Calculate the net present value for each project.
b. Calculate the IRR for each project.
c. What problem(s) do you foresee in selecting one of the projects?
d. What project should be selected?
ANSWER:
a. NPVX = $32,787 × 3.352 - $90,000
NPVX = $19,902
NPVY = $223,880 × .497 - $90,000
NPVY = $21,268
b. IRRX
$90,000 = 32,787 PVIFA[IRR%, 5 yr.]
2.745 = PVIFA[IRR%, 5 yr.]
24% = IRRX
IRRY
90,000 = 223,880 PVIF[IRR%, 5 yr.]
.402 = PVIF[IRR%, 5 yr.]
20% = IRRY
c. There is a conflict in the rankings of the projects.
Project NPV(15%) IRR
X $19,902 24%
Y $21,268 20%
d. Select Project Y because it has the highest NPV.
KEYWORDS: mutually exclusive, ranking conflicts
130. Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be
fully depreciated by the simplified straight line method over its 5 year depreciable life. Operating costs
of the new machine are expected to be $1,100,000 per year. The existing assembly line has 5 years
remaining before it will be fully depreciated and has a book value of $3,000,000. If sold today the
company would receive $2,400,000 for the existing machine. Annual operating costs on the existing
machine are $2,100,000 per year. Bull Gator is in the 46 percent marginal tax bracket and has a
required rate of return of 12 percent.
a. Calculate the net present value of replacing the existing machine.
b. Explain the impact on NPV of the following:
i. Required rate of return increases
ii. Operating costs of new machine are increased
iii. Existing machine sold for less
ANSWER:
a. Calculate Initial Outlay
Purchase Price $6,000,000
Sale of old (2,400,000)
Tax savings from sale
($3,000,000 - 2,400,000).46 (276,000)
Initial Outlay $3,324,000
29
Free Cash Flows
Change in EBDIT $1,000,000
-Increased Depreciation - 600,000
Change in EBIT $400,000
-Taxes (at 46%) - 184,000
+Change in Depreciation + 600,000
-Change in Working Capital - 0
-Change in Capital Spending - 0
$ 816,000
Depreciation on old machine
$3,000,000/5 = $600,000
Depreciation on new machine
$6,000,000/5 = $1,200,000
Increase Depreciation
= $600,000 - $1,200,000 = -$600,000
Calculate NPV
NPV = $816,000 × 3.605 - $3,324,000
NPV = -$382,320
b. i. NPV decreases
ii. NPV decreases
iii. NPV decreases
DIFFICULTY: Hard
KEYWORDS: project cash flows
131. AFX Industries purchased some agricultural land at the edge of a large metropolitan area for $200,000
five years ago. In order to have the land classified as agricultural for property tax purposes, the
company has been leasing the property to neighboring farmers. The increased EBIT (there is no change
in depreciation) from leasing the property is $8,000 per year. This company’s corporate tax rate is 46
percent. If the company sells the land for $300,000 today, what is the internal rate of return on this
investment?
ANSWER:
Initial investment at time 0 = $200,000
Free cash flows time 1–4 = (1 - .46)($8,000) = $4,320
Terminal after-tax cash flow time 5
$4,320 + $300,000 – (.46)($300,000 - $200,000) = $258,320
$200,000 = $4,320 PVIFA [IRR%, 4 yr]
+ $258,320 PVIF [IRR%, 5 yr]
IRR = 6.867%
KEYWORDS: project analysis, internal rate of return
132. Patrick Motors has several investment projects under consideration, all with positive net present values.
However, due to a shortage of trained personnel, a limit of $1,250,000 has been placed on the capital
budget for this year. Which of the projects listed below should be included in this year’s capital budget?
Project Initial Outlay NPV
A $ 250,000 $325,000
B 250,000 350,000
C 1,000,000 700,000
D 375,000 112,500
30
E 375,000 75,000
ANSWER:
Project P.I.
A 2.3
B 2.4
C 1.7
D 1.3
E 1.2
Select combination with highest NPV or PI
Ex. (1) NPV (A + B + D + E) = $862,500
or PI (A + B + D + E) = 1.69
(2) NPV (C + B) = $1,050,000
or PI (C + B) = 1.84
Projects B and C should be selected.
133. Describe the ways that conflicts in project rankings can be addressed.
ANSWER:
There are two ways to address the issues that cause conflicts in project rankings. The first method is the
replacement chain approach. This approach allows projects with uneven lives to be replicated until a
common number of years has been established. Once the cash flows have been replicated, NPV is
calculated to determine which project creates the best value. The project with the highest NPV is
selected.
The second method is the equivalent annuity approach. In this approach, the NPV is solved all projects
being analyzed. An annual cash flow is calculated, i.e. annuity, that yields the same present value as the
NPV. The project with the highest annuity payment is selected.
KEYWORDS: conflicts in project rankings
134. Two mutually exclusive projects are being evaluated using the accounting rate of return. Each project
has an initial outlay of $50,000 and salvage value of $10,000 after six years. The after-tax profits for
the two projects are:
Year Profit A Profit B
1 $5,000 $25,000
2 5,000 25,000
3 5,000 25,000
4 32,500 12,500
5 32,500 12,500
6 35,000 12,500
a. Calculate each project’s AROR.
b. Which project should be selected using this criterion? Do you
support the recommendation? Why or why not?
ANSWER:
Average investment = ($50,000 + $10,000)/2 = $30,000
Average Profit for Project A = $19,167
1/6($5,000 + $5,000 + $5,000 + $32,500 + $32,500 + $35,000)
Average Profit for Project B = $18,750
31
1/6(3 × $25,000 + 3 × $12,500)
a. ARORA = $19,167/$30,000 = 63.9%
ARORB = 18,750/$30,000 = 62.5%
b. Project A has a slightly higher AROR. However, the internal rate of
return for Project A is 22.3% while the internal rate of return for
Project B is 37.9%.
KEYWORDS: accounting rate of return
135. The Deacon Company is considering two mutually exclusive projects with depreciable lives of three
and six years. The after-tax cash flows for projects S and L are listed below.
Year Cash Flow S Cash Flow L
0 -$50,000 -$50,000
1 25,625 16,563
2 25,625 16,563
3 25,625 16,563
4 16,563
5 16,563
6 16,563
The required rate of return on these projects is 15 percent. Which project should be accepted?
ANSWER:
Calculate net present values
NPVS = $25,625 × 2.283 - $50,000
NPVS = $8,502
NPVL = $16,563 × 3.784 - $50,000
NPVL = $12,674
Create a replacement chain for S.
NPVS* = NPVS + NPVS × .658
NPVS = $8,502 + $8,502 × .658
NPVS = $14,096
Project S should be accepted.
KEYWORDS: mutually exclusive, choosing between projects
136. Company K is considering two mutually exclusive projects. The cash flows of the projects are as
follows:
Year Project A Project B
0 -$2,000 -$2,000
1 $500
2 $500
3 $500
4 $500
5 $500
32
6 $500
7 $500 $5,650
a. Compute the NPV and IRR for the above two projects, assuming a 13%
required rate of return.
b. Discuss the ranking conflict.
c. Which of these two projects should be chosen?
ANSWER:
a. NPVA = [$500/[(1 + 0.13)t]] - $2,000
= $2,211.30 - $2,000 = $211.3
NPVB = [$5,650/[(1 + 0.13)7]] - $2,000
= $2,401.59 - $2,000 = $401.59
IRR = $2,000 = $500 PVIFA[IRR%, 7 yr.]
Thus, IRRA = 16.3%
$2,000 = $5,650 PVIF[IRR%, 7 yr.]
Thus, IRRB = 15.99%
b. The conflicting rankings are caused by the differing reinvestment assumptions made by the NPV and
IRR decision criteria. The NPV criteria assumes that cash flows over the life of the project can be
reinvested at the required rate of return or cost of capital, while the IRR criterion implicitly assumes
that the cash flows over the life of the project can be reinvested at the internal rate of return.
c. Project B should be taken because it has the largest NPV. The NPV criterion is preferred because it
makes the most acceptable assumption for the wealth maximizing firm.
KEYWORDS: mutually exclusive, project conflicts
33

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Chapter 10

Cash Flow and Other Topics in Capital Budgeting

5. Working capital for a project includes investment in fixed assets.

37. Incremental cash flows include all of the following EXCEPT:

45. Which of the following should be included in the initial outlay?

46. Depreciation expenses affect capital budgeting analysis by increasing

47. Which of the following is included in the terminal cash flow?

61. Capital rationing may be imposed because:

72. Relevant incremental cash flows include:

75. The machine’s initial cash outflow is:

76. The machine’s incremental after-tax cash inflow is:

78. The machine’s NPV is:

79. The machine’s IRR is:

85. Increased taxes on the sale of the old machine are:

87. The incremental change in depreciation is:

88. The net incremental after-tax cash flow is:

89. The after-tax terminal cash flow is:

90. The NPV for this replacement decision is:

91. The IRR for this replacement decision is:

92. Problems in project ranking can occur due to:

93. The equivalent annual annuity for Project Y is:

94. The equivalent annual annuity for Project Z is:

95. The infinite-life replacement chain for Project Y is:

96. The infinite-life replacement chain for Project Z is:

97. Based on the information, you would:

100. Which of the following is an example of a sunk cost?

106. Depreciation expenses affect tax-related cash flows by:

107. Which of the following will increase free cash flow?

108. Which of the following would be considered a termination cash flow?

Year 1 Incremental Projections:

Calculate the operating cash flow for Year 1.

128. Consider the following two projects:

Initial Net Cash flow Each Period

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