BUS 30000 - Chapter 10

When calculating cash flows, one should consider them on an incremental basis. 1. True 2. False

1. True

Working capital is needed for additional investment within a project and should be included within cash-flow estimates. 1. True 2. False

1. True

The total depreciation tax shield equals the product of depreciation and the tax rate. 1. True 2. False

1. True

When additional funds must be committed to working capital, those funds are assumed to be recovered at the end of the project's life. 1. True 2. False

1. True

Hunter's Hut is considering a project that will require additional inventory of $176,000 and will increase accounts payable by $148,000. Accounts receivable is currently $305,000 and is expected to increase by 11 percent if this project is accepted. What is the project's initial cash flow for net working capital? 1. -$61,550 2. -$5,550 3. -$112,250 4. -$366,550 5. -$357,550

1. -$61,550 NWC requirement = -$176,000 + $148,000 - ($305,000 ×.11) = - $61,550

Changes in the net working capital requirements: 1. Can affect the cash flows of a project every year of the project's life. 2. Only affect the initial cash flows of a project. 3. Only affect the initial and final cash flows of a project. 4. Are generally excluded from project analysis due to their irrelevance to the total project. 5. Are excluded from the analysis as long as they are recovered when the project ends.

1. Can affect the cash flows of a project every year of the project's life.

The difference between a firm's future cash flows if it accepts a project and the firm's future cash flows if it does not accept the project is referred to as the project's: 1. Incremental cash flows. 2. Internal cash flows. 3. External cash flows. 4. Erosion effects. 5. Financing cash flows.

1. Incremental cash flows.

An asset in the MACRS 5-year class life will have depreciation expense in 6 different years. 1. True 2. False

1. True

As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected. 1. True 2. False

1. True

Capital budgeting analysis focuses on cash flow as opposed to profits. 1. True 2. False

1. True

Depreciation expense acts as a tax shield in reducing taxes. 1. True 2. False

1. True

If a project permits a reduction in the level of working capital, this reduction is assumed to increase cash flows. 1. True 2. False

1. True

Sunk costs are bygones (i.e., they are unaffected by the decision to accept or reject a project). They should therefore be ignored. 1. True 2. False

1. True

Sunk costs do not affect the net present value of a project. 1. True 2. False

1. True

Sunk costs remain the same whether or not you accept the project. 1. True 2. False

1. True

Suppose you finance a project partly with debt. You should neither subtract the debt proceeds from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows. 1. True 2. False

1. True

Which one of the following is an example of a sunk cost? 1. $1,500 of lost sales because an item was out of stock. 2. $1,200 paid to repair a machine last year. 3. $20,000 project that must be forfeited if another project is accepted. 4. $4,500 reduction in current shoe sales if a store commences selling sandals. 5. $1,800 increase in comic book sales if a store ceases selling puzzles.

2. $1,200 paid to repair a machine last year.

Dependable Motors just purchased some MACRS 5-year property at a cost of $216,000. The MACRS rates are .2, .32, and .192 for years 1 to 3, respectively. Which one of the following will correctly give you the book value of this equipment at the end of year 2? 1. $216,000 / (1 + .2 + .32) 2. $216,000 ×(1 - .2 - .32) 3. $216,000 ×(.20 + .32) 4. [$216,000 ×(1 - .20)] ×(1 - .32) 5. $216,000 / [(1 + .20)(1 + .32)]

2. $216,000 ×(1 - .2 - .32)

Kelly's Corner Bakery purchased a lot in Oil City six years ago at a cost of $278,000. Today, that lot has a market value of $264,000. At the time of the purchase, the company spent $6,000 to level the lot and another $8,000 to install storm drains. The company now wants to build a new facility on that site. The building cost is estimated at $1.03 million. What amount should be used as the initial cash flow for this project? 1. -$1,308,000 2. -$1,294,000 3. -$1,322,000 4. -$1,308,000 5. -$1,045,000

2. -$1,294,000 CF0 = -$264,000 - 1,030,000 = -$1,294,000

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows. 1. True 2. False

2. False

Investments in working capital, just like investments in plant and equipment, result in cash inflows at time zero. 1. True 2. False

2. False

Opportunity costs should not be included in project analysis, as they are missed opportunities. 1. True 2. False

2. False

Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows. 1. True 2. False

2. False

All of the following are related to a proposed project. Which one of these should be included in the cash flow at Time 0? 1. Loan obtained to finance the project 2. Initial investment in inventory to support the project 3. Annual depreciation tax shield 4. Aftertax salvage value 5. Net working capital recovery

2. Initial investment in inventory to support the project

The current book value of a fixed asset that was purchased two years ago is used in the computation of which one of the following? 1. Depreciation tax shield. 2. Tax due on the salvage value of that asset. 3. Current year's operating cash flow. 4. Change in net working capital. 5. MACRS depreciation for the current year.

2. Tax due on the salvage value of that asset.

The bottom-up approach to computing the operating cash flow applies only when: 1. Both the depreciation expense and the interest expense are equal to zero. 2. The interest expense is equal to zero. 3. The project is a cost-cutting project. 4. No fixed assets are required for a project. 5. Both taxes and the interest expense are equal to zero.

2. The interest expense is equal to zero.

A proposed expansion project is expected to increase sales of JJ's Store by $58,000 and increase cash expenses by $36,100. The project will require $36,900 of fixed assets that will be depreciated using straight-line depreciation to a zero book value over the three-year life of the project. The store has a marginal tax rate of 35 percent. What is the operating cash flow of the project using the tax shield approach? 1. $25,600 2. $17,900 3. $18,540 4. $22,800 5. $14,600

3. $18,540 OCF = ($58,000 - 36,100) (1 - .35) + ($36,900 / 3) (.35) = $18,540

A proposed three-year project will require $627,000 for fixed assets, $169,000 for inventory, and $43,000 for accounts receivable. Accounts payable are expected to increase by $178,000. The fixed assets will be depreciated straight-line to a zero book value over five years. At the end of the project, the fixed assets can be sold for $225,000. The net working capital returns to its original level at the end of the project. The operating cash flow per year is $62,000. The tax rate is 35 percent and the discount rate is 12 percent. What is the total cash flow in the final year of the project? 1. $292,250 2. $321,000 3. $330,030 4. $311,970 5. $322,770

3. $330,030 Net working capital recovery = $169,000 + 43,000 - 178,000 = $34,000 Book value3 = $627,000 / 5 × 2 = $250,800 CF3 = $62,000 + 34,000 + 225,000 + ($250,800 - 225,000)(.35) = $330,030

Jefferson & Sons is evaluating a project that will increase annual sales by $145,000 and annual cash costs by $94,000. The project will initially require $110,000 in fixed assets that will be depreciated straight-line to a zero book value over the four-year life of the project. The applicable tax rate is 32 percent. What is the operating cash flow for this project? 1. $11,220 2. $29,920 3. $43,480 4. $46,480 5. $46,620

3. $43,480 OCF = ($145,000 - 94,000)(1 - .32) + ($110,000 / 4)(.32) = $43,480

High Breeze currently produces boat sails and is considering expanding into awnings for homes and travel trailers. The company owns land that could be used for the expansion. The company bought the land 5 years ago at a cost of $319,000 and is valued today at $395,000. The company has some unused equipment that it currently owns valued at $38,000. This equipment could be used for producing awnings if $12,000 is spent for equipment modifications. Other equipment costing $138,000 will also be required. What is the amount of the initial cash flow for this expansion project? 1. -$571,000 2. -$469,000 3. -$583,000 4. -$507,000 5. -$545,000

3. -$583,000 CF0 = -$395,000 - 38,000 - 12,000 - 138,000 = -$583,000

Which one of the following best describes pro forma financial statements? 1. Financial statements expressed in a foreign currency. 2. Financial statements where the assets are expressed as a percentage of total assets and costs are expressed as a percentage of sales. 3. Financial statements showing projected values for future time periods. 4. Financial statements expressed in real dollars, given a stated base year. 5. Financial statements where all accounts are expressed as a percentage of last year's values.

3. Financial statements showing projected values for future time periods.

Which one of the following is a correct method for computing the operating cash flow of a project assuming that the interest expense is equal to zero? 1. EBIT + Depreciation 2. EBIT - Taxes 3. Net income + Depreciation 4. (Sales - Costs) ×(1 - Depreciation) ×(1- Taxes) 5. (Sales - Costs) ×(1 - Taxes)

3. Net income + Depreciation

Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach? 1. Providing both ketchup and mustard for customers' use. 2. Repairing the roof of the hot dog stand because of water damage. 3. Selling fewer hot dogs because hamburgers were added to the menu. 4. Offering French fries but not onion rings. 5. Losing sales due to bad weather.

3. Selling fewer hot dogs because hamburgers were added to the menu.

Which one of the following costs was incurred in the past and cannot be recouped? 1. Incremental. 2. Side. 3. Sunk. 4. Opportunity. 5. Erosion.

3. Sunk.

Which one of the following best describes the concept of erosion? 1. Expenses that have already been incurred and cannot be recovered. 2. Change in net working capital related to implementing a new project. 3. The cash flows of a new project that come at the expense of a firm's existing cash flows. 4. The alternative that is forfeited when a fixed asset is utilized by a project. 5. The differences in a firm's cash flows with and without a particular project.

3. The cash flows of a new project that come at the expense of a firm's existing cash flows.

Dexter Smith & Co. is replacing a machine simply because it has worn out. The new machine will not affect either sales or operating costs and will not have any salvage value at the end of its five-year life. The firm has a 34 percent tax rate, uses straight-line depreciation over an asset's life, and has a positive net income. Given this, which one of the following statements is correct? 1. As a project, the new machine has a net present value equal to minus one times the machine's purchase price. 2. The new machine will have a zero rate of return. 3. The new machine will generate positive operating cash flows. 4. The new machine will create a cash outflow when the firm disposes of it at the end of its life. 5. The new machine creates erosion effects.

3. The new machine will generate positive operating cash flows.

Nelson Mfg. owns a manufacturing facility that is currently sitting idle. The facility is located on a piece of land that originally cost $159,000. The facility itself cost $1,390,000 to build. As of now, the book value of the land and the facility are $159,000 and $458,000, respectively. The firm owes no debt on either the land or the facility at the present time. The firm received a bid of $1,700,000 for the land and facility last week. The firm's management rejected this bid even though they were told that it is a reasonable offer in today's market. If the firm was to consider using this land and facility in a new project, what cost, if any, should it include in the project analysis? 1. $0 2. $617,000 3. $1,083,000 4. $1,700,000 5. $1,619,000

4. $1,700,000 Relevant cost = $1,700,000

Cool Comfort currently sells 300 Class A spas, 450 Class C spas, and 200 deluxe model spas each year. The firm is considering adding a mid-class spa and expects that, if it does, it can sell 375 of them. However, if the new spa is added, Class A sales are expected to decline to 225 units while the Class C sales are expected to decline to 200. The sales of the deluxe model will not be affected. Class A spas sell for an average of $12,000 each. Class C spas are priced at $6,000 and the deluxe model sells for $17,000 each. The new mid-range spa will sell for $8,000. What is the value of the erosion? 1. $600,000 2. $1,200,000 3. $1,800,000 4. $2,400,000 5. $3,900,000

4. $2,400,000 Erosion = [(300 - 225) �$12,000] + [(450 - 200) �$6,000] = $2,400,000

Pet Supply purchased some fixed assets two years ago at a cost of $43,800. It no longer needs these assets so it is going to sell them today for $32,500. The assets are classified as five-year property for MACRS. The MACRS rates are .2, .32, .192, .1152, .1152, .0576, for years 1 to 6, respectively. What is the net cash flow from this sale if the firm's tax rate is 35 percent? 1. $36,516.60 2. $18,576.00 3. $7,459.40 4. $28,483.40 5. $25,211.09

4. $28,483.40 Book value2 = $43,800 ×(1 - .20 - .32) = $21,024 Aftertax salvage = $32,500 + [($21,024 - 32,500) ×.35] = $28,483.40

A project has projected sales of $26,000, cash expenses of $18,500, depreciation of $1,730, taxes of $1,400, and an initial cash requirement of $2,200 for working capital. What is the amount of the operating cash flow using the top-down approach? 1. $4,370 2. $3,900 3. $8,300 4. $6,100 5. $8,900

4. $6,100 OCF = $26,000 - 18,500 - 1,400 = $6,100

The depreciation tax shield is best defined as the: 1. Amount of tax that is saved when an asset is purchased. 2. Tax that is avoided when an asset is sold as salvage. 3. Amount of tax that is due when an asset is sold. 4. Amount of tax that is saved because of the depreciation expense. 5. Amount by which the aftertax depreciation expense lowers net income.

4. Amount of tax that is saved because of the depreciation expense.

Net working capital: 1. Can be ignored in project analysis because any expenditure is normally recouped at the end of the project. 2. Requirements, such as an increase in accounts receivable, create a cash inflow at the beginning of a project. 3. Is rarely affected when a new product is introduced. 4. Can create either an initial cash inflow or outflow. 5. Is the only expenditure where at least a partial recovery can be made at the end of a project.

4. Can create either an initial cash inflow or outflow.

The operating cash flow for a project should exclude which one of the following? 1. Taxes. 2. Variable costs. 3. Fixed costs. 4. Interest expense. 5. Depreciation tax shield.

4. Interest expense.

Which one of the following should not be included in the analysis of a new product? 1. Increase in accounts payable for new product inventory purchases. 2. Reduction in sales for a current product once the new product is introduced. 3. Market value of a machine owned by the firm which will be used to produce the new product. 4. Money already spent for research and development of the new product. 5. Increase in accounts receivable needed to finance sales of the new product.

4. Money already spent for research and development of the new product.

The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following? 1. Salvage value. 2. Wasted value. 3. Sunk cost. 4. Opportunity cost. 5. Erosion.

4. Opportunity cost.

The Lunch Counter is expanding and expects operating cash flows of $32,500 a year for seven years as a result. This expansion requires $28,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires $2,800 of net working capital throughout the life of the project. What is the net present value of this expansion project at a required rate of return of 14 percent? 1. $111,369.91 2. $121,033.33 3. $98,288.70 4. $108,569.91 5. $109,688.89

5. $109,688.89 NPV = -$28,000 - 2,800 + $32,500({1 - [1 / (1.14)7]} / .14) + $2,800 / 1.147 NPV = $109,688.89

Marie's Fashions is considering a project that will require $41,000 in net working capital and $64,000 in fixed assets. The project is expected to produce annual sales of $62,000 with associated cash costs of $41,000. The project has a 3-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 34 percent. What is the operating cash flow for this project? 1. -$220.00 2. -$17,580.00 3. $16,421.15 4. $25,760.00 5. $21,113.33

5. $21,113.33 OCF = ($62,000 - 41,000)(1 - .34) + ($64,000 / 3)(.34) = $21,113.33

The Card Shoppe needs to maintain 18 percent of its sales in net working capital. Currently, the store is considering a four-year project that will increase sales from its current level of $279,000 to $308,000 the first year and to $314,000 a year for the following three years of the project. What amount should be included in the project analysis for net working capital in Year 4 of the project? 1. -$6,300 2. -$720 3. $0 4. $720 5. $6,300

5. $6,300 NWC recovery = ($314,000 - 279,000) ×.18 = $6,300

P.A. Petroleum just purchased some equipment at a cost of $67,000. The equipment is classified as MACRS 5-year property. The MACRS rates are .2, .32, .192, .1152, .1152, and .0576 for years 1 to 6, respectively. What is the proper methodology for computing the depreciation expense for Year 2? 1. $67,000 ×(1 - .20) ×.32 2. $67,000 / (1 - .20 - .32) 3. $67,000 ×(1 + .32) 4. $67,000 ×(1 - .32) 5. $67,000 ×.32

5. $67,000 ×.32

Better Beverages purchased some fixed assets classified as five-year property for MACRS. The assets cost $108,000. The MACRS rates are .2, .32, .192, .1152, .1152, and .0576 for years 1 to 6, respectively. What will the accumulated depreciation be at the end of Year 4? 1. $101,779.20 2. $25,056.67 3. $42,002.89 4. $48,755.09 5. $89,337.60

5. $89,337.60 Accumulated depreciation4 = $108,000 ×(.2 + .32 + .192 + .1152) Accumulated depreciation4 = $89,337.60

Pro forma statements for a proposed project should generally do all of the following except: 1. Be compiled on a stand-alone basis. 2. Include all project-related fixed asset acquisitions and disposals. 3. Include all the incremental cash flows related to the project. 4. Include taxes. 5. Include interest expense.

5. Include interest expense.

You own some equipment that you purchased four years ago at a cost of $287,000. The equipment is five-year property for MACRS. The MACRS rates are .2, .32, .192, .1152, .1152, .0576, for years 1 to 6, respectively. You are considering selling the equipment today for $99,000. Which one of the following statements is correct if your tax rate is 35 percent? 1. The tax due on the sale is $17,357.76. 2. The book value today is $49,406.40. 3. The accumulated depreciation to date is $270,468.80. 4. The taxable amount on the sale is $49,593.60. 5. The aftertax salvage value is $81,707.76.

5. The aftertax salvage value is $81,707.76. Accumulated depreciation4 = $287,000 ×(.20 + .32 + .192 + .1152) = $237,406.40 Book value4 = $287,000 - 237,406.40 = $49,593.60 Taxable gain on sale = $99,000 - 49,593.60 = $49,406.40 Tax due = $49,406.40 ×.35 = $17,292.24 Aftertax salvage value = $99,000 - 17,292.24 = $81,707.76