Finance Test 3 Ch. 11

10) Cash flows that could be realized from the best alternative use of an owned asset are called ________. A) incremental costs B) lost resale opportunities C) opportunity costs D) sunk costs

C

17) ________ reflects the return that must be earned on the given project to compensate the firm's owners adequately. A) Internal rate of return B) Cost of capital C) Risk-adjusted discount rate D) Average rate of return

C

20) If a firm has a limited capital budget to fund its capital projects, it is said to be facing the problem of ________. A) constrained capital B) wealth optimization C) capital rationing D) profitability

C

9) Should financing costs such as the returns paid to bondholders and stockholders be considered in computing after-tax operating cash flows? Why or why not?

Financing costs are not an incremental cash flow for capital budgeting purposes. Financing costs are a direct consequence of how the project is financed, not whether the project is economically viable. Financing costs are embedded in the required rate of return used to discount project cash flows.

8) Real options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability.

TRUE

8) The break even cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

TRUE

8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market risk premium.

TRUE

9) Projects with a small chance of being acceptable and a broad range of possible cash flows are riskier than projects having a high chance of being acceptable and a narrow range of possible cash flows.

TRUE

76) Compute the initial purchase price for an asset with book value of $34,800 and total accumulated depreciation of $85,200.

Initial purchase price = Book value + Accumulated depreciation = $34,800 + $85,200 = $120,000

Table 11.2 Computer Disk Duplicators, Inc. has been considering several capital investment proposals for the year beginning in 2014. For each investment proposal, the relevant cash flows and other relevant financial data are summarized in the table below. In the case of a replacement decision, the total installed cost of the equipment will be partially offset by the sale of existing equipment. The firm is subject to a 40 percent tax rate on ordinary income and on long-term capital gains. The firm's cost of capital is 15 percent. Type of Capital Budgeting Decision 1(Independent) 2(Mut exu 3) 3(Mut exu 2) Cost of new asset 1500000 200000 300000 Installation costs 0 0 15000 MACRS (new) 10 yr 5 yr 5 yr Original cost of old asset N/A 80000 100000 Ourchase date N/A 1/1/2010 1/1/2010 Sales proceeds N/A 50000 120000 MACRS (old) N/A 5 yr 5 yr Annual net profits before depr (old) N/A 30000 25000 Annual net profits before depr (new) 250000 100000 175000 26) For Proposal 1, the cash flow pattern for the expansion project is ________. (See Table 11.2) A) a mixed stream and conventional B) a mixed stream and nonconventional C) a perpetuity and conventional D) an annuity and nonconventional 27) For Proposal 1, the initial outlay equals ________. (See Table 11.2) A) $1,380,000 B) $1,440,000 C) $1,500,000 D) $1,620,000 28) For Proposal 1, the depreciation expense for year 1 is ________. (See Table 11.2) A) $110,400 B) $115,200 C) $150,000 D) $300,000 29) For Proposal 1, the annual incremental after-tax cash flow from operations for year 1 is ________. (See Table 11.2) A) $60,000 B) $255,000 C) $300,000 D) $210,000 30) For Proposal 2, the cash flow pattern for the replacement project is ________. (See Table 11.2) A) a mixed stream and conventional B) a mixed stream and nonconventional C) a perpetuity and conventional D) an annuity and nonconventional 31) For Proposal 2, the book value of the existing asset at the end of the fifth year is ________. (See Table 11.2) A) $13,600 B) $34,400 C) $66,400 D) $80,000 32) For Proposal 2, the tax effect on the sale of the existing asset at the end of the fifth year results in ________. (See Table 11.2) A) $12,000 tax liability B) $14,560 tax liability C) $25,280 tax liability D) $16,600 tax liability 33) For Proposal 2, the initial outlay equals ________. (See Table 11.2) A) $120,720 cash outflow B) $164,560 cash outflow C) $150,000 cash outflow D) $167,520 cash outflow 34) For Proposal 2, the incremental depreciation expense for year 2 is ________. (See Table 11.2) A) $16,800 B) $26,400 C) $38,400 D) $60,000 35) For Proposal 2, the annual incremental after-tax cash flow from operations for year 2 is ________. (See Table 11.2) A) $18,000 B) $24,000 C) $56,000 D) $84,000 36) For Proposal 3, the cash flow pattern for the replacement project is ________. (See Table 11.2) A) a mixed stream and conventional B) a mixed stream and nonconventional C) a perpetuity and conventional D) an annuity and nonconventional 37) For Proposal 3, the book value of the existing asset is ________. (See Table 11.2) A) $21,000 B) $43,000 C) $52,000 D) $80,000 38) For Proposal 3, the tax effect on the sale of the existing asset results in ________. (See Table 11.2) A) $8,000 tax liability B) $16,000 tax liability C) $20,000 tax liability D) $23,200 tax liability 39) For Proposal 3, the initial outlay equals ________. (See Table 11.2) A) $170,400 B) $211,000 C) $196,000 D) $300,000 40) For Proposal 3, the incremental depreciation expense for year 3 is ________. (See Table 11.2) A) $21,000 B) $42,000 C) $47,850 D) $50,850 41) For Proposal 3, the incremental depreciation expense for year 6 is ________. (See Table 11.2) A) $15,750 B) $10,750 C) $23,000 D) $36,150 42) For Proposal 3, the annual incremental after-tax cash flow from operations for year 3 is ________. (See Table 11.2) A) $45,000 B) $75,150 C) $90,150 D) $93,800

26 A 27 C 28 C 29 D 30 A 31 A 32 B 33 B 34 D 35 C 36 A 37 D 38 B 39 B 40 C 41 A 42 D

75) A corporation has decided to replace an existing asset with a newer model. Two years ago, the existing asset originally cost $70,000 and was being depreciated under MACRS using a five-year recovery period. The existing asset can be sold for $30,000. The new asset will cost $80,000 and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax rate is 40 percent on ordinary income and capital gains, the initial investment is ________. A) $48,560 B) $44,360 C) $49,240 D) $27,600

A

20) Behavioral approaches ________. A) are used to explicitly recognize project risk B) are used to get a feel for project risk C) are not used by rational financial managers D) are used to quantify the risk

B

20) The theoretical basis from which the concept of risk-adjusted discount rates is derived is ________. A) the Gordon model B) the capital asset pricing model C) simulation theory D) the basic cost of money

B

65) The tax treatment regarding the sale of existing assets that are sold for their book value results in ________. A) an ordinary tax benefit B) no tax benefit or liability C) recaptured depreciation taxed as ordinary income D) a capital gain tax liability and recaptured depreciation taxed as ordinary income

B

73) A loss on the sale of an asset that is depreciable and used in business is ________ a loss on the sale of a non-depreciable asset is ________. A) deductible from capital gains income: deductible from ordinary income B) deductible from ordinary income: deductible only against capital gains C) a credit against the tax liability: not deductible D) not deductible: deductible only against capital gains

B

8) Relevant cash flows for a project are best described as ________. A) incidental cash flows B) incremental cash flows C) sunk cash flows D) contingent cash flows

B

93) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must estimate the terminal cash flow. The proposed machine will be disposed of at the end of its usable life of five years at an estimated sale price of $15,000. The machine has an original purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________. A) $24,000 B) $16,000 C) $14,000 D) $26,000

B

95) Which of the following must be considered in computing the terminal value of a replacement project? A) operating cash flow for the final year B) after-tax proceeds from the sale of a new asset C) before-tax proceeds from the sale of an old asset D) before-tax proceeds from the sale of a new asset

B

63) The tax treatment regarding the sale of existing assets that are sold for more than the original purchase price results in ________. A) an ordinary tax benefit B) no tax benefit or liability C) a recaptured depreciation taxed as ordinary income D) a capital gain tax liability

D

69) A corporation is selling an existing asset for $21,000. The asset, when purchased, cost $10,000, was being depreciated under MACRS using a five-year recovery period, and has been depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is ________. A) $0 tax liability B) $7,560 tax liability C) $4,400 tax liability D) $7,720 tax liability

D

71) A corporation is selling an existing asset for $1,000. The asset, when purchased, cost $10,000, was being depreciated under MACRS using a five-year recovery period, and has been depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is ________. A) $0 tax liability B) $1,100 tax liability C) $3,600 tax liability D) $280 tax benefit

D

12) The objective of capital rationing is to select the group of projects that provides the quickest overall payback and does not require more dollars than are budgeted.

FALSE

4) A sunk cost is a cash flow that could be realized from the best alternative use of an owned asset.

FALSE

4) The risk-adjusted discount rate approach to evaluating projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

FALSE

6) The three major cash flow components include the initial investment, nonoperating cash flows, and terminal cash flow.

FALSE

8) Recaptured depreciation is the portion of the sale price that is in excess of the initial purchase price.

FALSE

9) Futures and options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability.

FALSE

9) If an asset is depreciable and used in business, any loss on the sale of the asset is tax-deductible only against other capital gains income, not against ordinary income.

FALSE

9) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the credit risk premium.

FALSE

11) If an asset is sold for book value, the gain on the sale is composed of two parts: a capital gain and accumulated depreciation.

FALSE Diff: 1

7) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

False

12) If an asset is sold for less than its book value, the loss on the sale may be used to offset ordinary operating income provided the asset is used in the business.

TRUE

12) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.

TRUE

12) The higher the risk-adjusted net present, the more viable the project.

TRUE

14) Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify the risk on their own.

TRUE

2) Relevant cash flows are the incremental cash outflows and inflows associated with a proposed capital expenditure.

TRUE

2) Sunk costs are cash outlays that have already been made and therefore have no effect on the cash flows relevant to the current decision.

TRUE

4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.

TRUE

4) Incremental cash flows represent the additional cash flows expected as a direct result of the proposed project.

TRUE

5) An opportunity cost is a cash flow that could be realized from the best alternative use of an owned asset.

TRUE

5) Annualized net present value approach is the most efficient technique for dealing with projects of unequal lives.

TRUE

5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate (RADR) approach implicitly assumes that risk is an increasing function of time.

TRUE

5) In case of an existing asset which is depreciable and is used in business and is sold for a price equal to its initial purchase price, the difference between the sales price and its book value is considered as recaptured depreciation and will be taxed as ordinary income.

TRUE

5) The three major cash flow components include the initial investment, operating cash flows, and terminal cash flow.

TRUE

6) A sunk cost is a cash outlay that has already been made and cannot be recovered.

TRUE

6) In capital budgeting, risk is the degree of variability of cash flows.

TRUE

6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

TRUE

7) Capital gain is the portion of the sale price that is in excess of the initial purchase price.

TRUE

7) For assets traded in an efficient market, the diversifiable risk can be eliminated through diversification.

TRUE

1) Accounting figures and cash flows are not necessarily the same due to the presence of certain non-cash expenditures on a firm's income statement.

TRUE Diff: 1

4) The book value of an asset is equal to its installed cost of asset minus the accumulated depreciation.

TRUE Diff: 1

18) The difference by which the required discount rate exceeds the risk-free rate is called the ________. A) excess return B) risk premium C) inflation premium D) maturity premium

B

8) In developing the cash flows for an expansion project, the analysis is the same as the analysis for replacement projects where ________. A) all cash flows from the old assets are equal B) prior cash flows are irrelevant C) all cash flows from the old asset are zero D) cash inflows equal cash outflows

C

85) Which of the following basic variables must be considered in determining the initial investment associated with a capital expenditure? A) incremental annual savings produced by the new asset B) cash flows generated by the new investment C) proceeds from the sale of an existing asset D) profits on the sale of an existing asset

C

19) A preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint, is ________. A) sensitivity analysis B) simulation analysis C) scenario analysis D) risk-adjusted discount rates

D

86) An important cash inflow in the analysis of initial cash flows for a replacement project is ________. A) taxes B) the cost of the new asset C) installation cost D) the sale value of the old asset

D

1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

FALSE

10) In capital budgeting, risk refers to a high degree of variability of the initial investment of a project.

FALSE

15) By combining two projects with negatively correlated cash inflows, a firm reduces the combined cash inflow variability and its risk.

FALSE

1) Different projects have different levels of risk. As a result, the acceptance of a particular project generally has an impact on a firm's overall risk.

TRUE

4) Behavioral approaches for dealing with risk include scenario analysis and simulation.

TRUE

7) The annualized net present value approach used to evaluate projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

TRUE

78) An asset was purchased three years ago for $100,000 and can be sold for $40,000 today. The asset has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gain. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm's tax liability.

(a) Book Value = $100,000 (1 - 0.20 - 0.32 - 0.19) = $29,000 Recaptured depreciation = $40,000 - $29,000 = $11,000 Capital gain = 0 $11,000 (b) Tax liability = 11,000 × 0.40 = $4,400

79) A machine was purchased two years ago for $120,000 and can be sold for $50,000 today. The machine has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gains. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm's tax liability.

(a) Book Value = $120,000 (1 - 0.20 - 0.32) = $57,600 Recaptured depreciation = $0 Capital loss = $57,600 - $50,000 = $7,600 (b) Tax benefit = $7,600 × 0.40 = $3,040

77) A mixer was purchased two years ago for $120,000 and can be sold for $125,000 today. The mixer has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gain. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm's tax liability.

(a) Book Value = $120,000 (1 - 0.20 - 0.32) = $57,600 Recaptured depreciation = $125,000 - $57,600 = $67,400 Capital gain = $125,000 - $120,000 = $5,000 $72,400 (b) Tax liability = 72,400 × 0.40 = $28,960

A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf). Initial Inv. Year 1M Cash inflow 1 500,000 2 500,000 3 500,000 21) The net present value without adjusting the discount rate for risk is ________. (See Table 11.7) A) $336,000 B) $250,000 C) $179,400 D) $87,000 22) The discount rate that should be used in the net present value calculation to compensate for risk is ________. (See Table 11.7) A) 6 percent B) 15 percent C) 18 percent D) 24 percent 23) The net present value of the project when adjusting for risk is ________. (See Table 11.7) A) -$9,300 B) $0 C) $87,000 D) $105,000

21. D 22. D 23. A

Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 10 percent. ProjA ProjB Init Inv. 350000 425000 Yr. Cash Inflows 1 140000 175000 2 165000 150000 3 190000 125000 4 100000 5 75000 6 50000 22) The NPVs of Projects A and B are ________. (See Table 11.11) A) $95,066 and $56,386, respectively B) $56,386 and $95,066, respectively C) -$56,386 and -$95,066, respectively D) $45,000 and $650,000, respectively 23) The annualized NPV of Project A is ________. (See Table 11.11) A) $22,674 B) $12,947 C) $38,227 D) $21,828 24) The annualized NPV of Project B is ________. (See Table 11.11) A) $11,673 B) $12,947 C) $38,227 D) $21,828 25) Which project should be chosen on the basis of the normal NPV approach? (See Table 11.11) A) Project A because its NPV is higher B) Project B because its NPV is higher C) Project A because its IRR is higher D) Project B because its IRR is higher 26) Which project should be chosen using the Annualized NPV approach? (See Table 11.11) A) Project A because its annualized NPV is higher B) Project B because its NPV is higher C) Project A because its IRR is higher D) Project B because its annualized NPV is higher

22 B 23 A 24 D 25 B 26 A

Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40. ProjectM ProjectN In. Inv. $700,000 $780,000 Year Cash inflows 1 300000 220000 2 300000 320000 3 300000 380000 4 300000 460000 24) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project M is ________. (See Table 11.8) A) $156,494 B) $122,970 C) $85,732 D) $500,000 25) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project N is ________. (See Table 11.8) A) $166,132 B) $122,970 C) $85,732 D) $600,000 26) Using the risk-adjusted discount rate method of project evaluation, the better investment for Tangshan Mining is ________. (See Table 11.8) A) Project M because it has a higher NPV B) Project N because it has a higher NPV C) Project N because it has a higher IRR D) Project M because it has a higher IRR 27) Which project would be preferable if both projects were of average risk as the overall firm and Tangshan Mining has a beta of 1.0? (See Table 11.8) A) Project M because it has a higher NPV B) Project N because it has a higher NPV C) Project N because it has a higher IRR D) Project M because it has a higher IRR

24 B 25 C 26 A 27 B

Table 11.3 Cuda Marine Engines, Inc. must develop the relevant cash flows for a replacement capital investment proposal. The proposed asset costs $50,000 and has installation costs of $3,000. The asset will be depreciated using a five-year recovery schedule. The existing equipment, which originally cost $25,000 and will be sold for $10,000, has been depreciated using an MACRS five-year recovery schedule and three years of depreciation has already been taken. The new equipment is expected to result in incremental before-tax net profits of $15,000 per year. The firm has a 40 percent tax rate. 43) The cash flow pattern for the capital investment proposal is ________. (See Table 11.3) A) a mixed stream and conventional B) a mixed stream and nonconventional C) a perpetuity and conventional D) an annuity and nonconventional 44) The book value of the existing asset is ________. (See Table 11.3) A) $7,250 B) $15,000 C) $21,250 D) $25,000 45) The tax effect on the sale of the existing asset results in ________. (See Table 11.3) A) $800 tax benefit B) $1,000 tax liability C) $1,100 tax liability D) $6,000 tax liability 46) The initial outlay equals ________. (See Table 11.3) A) $41,100 B) $44,100 C) $38,800 D) $38,960 47) The incremental depreciation expense for year 1 is ________. (See Table 11.3) A) $2,250 B) $7,600 C) $7,000 D) $7,950 48) The incremental depreciation expense for year 5 is ________. (See Table 11.3) A) $2,250 B) $5,110 C) $7,950 D) $6,360 49) The annual incremental after-tax cash flow from operations for year 1 is ________. (See Table 11.3) A) $13,950 B) $16,600 C) $25,600 D) $30,000

43 A 44 A 45 C 46 B 47 B 48 D 49 B

15) A(n) ________ allows management to avoid or minimize losses on projects that turn bad. A) abandonment option B) growth option C) timing option D) put option

A

18) The objective of ________ is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted. A) capital rationing B) scenario analysis C) real options D) sensitivity analysis

A

21) Breakeven cash inflow refers to ________. A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV greater than zero B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less than zero C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less than zero cost of capital D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals zero

A

23) In capital budgeting, risk refers to ________. A) the degree of variability of the cash inflows B) the degree of variability of the initial investment C) the chance that the net present value will be greater than zero D) the chance that the internal rate of return will exceed the cost of capital

A

25) One basic technique used to evaluate after-tax operating cash flows is to ________. A) add noncash charges to net income B) subtract depreciation from operating revenues C) add cash expenses to net income D) subtract cash expenses from noncash charges

A

70) A corporation is selling an existing asset for $1,700. The asset, when purchased, cost $10,000, was being depreciated under MACRS using a five-year recovery period, and has been depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is ________. A) $0 tax liability B) $840 tax liability C) $3,160 tax liability D) $3,160 tax benefit

A

21) An approach to capital rationing that involves graphing project returns in descending order against the total dollar investment to determine the group of acceptable projects is called the ________. A) net present value approach B) internal rate of return approach C) payback approach D) profitability index approach

B

24) Benefits expected from proposed capital expenditures ________. A) must be on a pre-tax basis because it provides the true position of profits by the firm B) must be on an after-tax basis because no benefits may be used until tax claims are satisfied C) may be valued either on pre-tax or after-tax basis based on the size of the firm D) are independent of interest and taxes

B

24) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the project is ________. A) $1,000,000 B) $131,474 C) $100,000 D) $66,667

B

27) A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must evaluate the projects using the annualized net present value approach and recommend which project they should select. The firm's cost of capital has been determined to be 14 percent, and the projects have the following initial investments and cash flows: ProjR ProjS Int Inv. 40000 58000 Cash fl 1 20000 30000 2 20000 55000 3 20000 4 20000 A) Choose Project R because its ANPV is $6459 B) Choose Project S because its ANPV is $6459 C) Choose Project R because its ANPV is $18,274 D) Choose Project S because its ANPV is $10,637

B

28) A behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number variables of a project is called ________. A) sensitivity analysis B) scenario analysis C) simulation analysis D) Monte Carlo simulation

B

29) The advantage of using simulation in the capital budgeting process is the ________. A) ease of calculation over scenario analysis B) continuum of risk-return trade-offs for decision making C) single point estimate that helps the decision maker to choose the most accurate alternative D) use of several possible outcomes to asses risk

B

66) The portion of an asset's sale price that is above its book value and below its initial purchase price is called ________. A) a capital gain B) recaptured depreciation C) a capital loss D) book value

B

68) The tax treatment regarding the sale of existing assets that are sold for less than the book value results in ________. A) an ordinary tax benefit B) a capital loss tax benefit C) recaptured depreciation taxed as ordinary income D) a capital gain tax liability and recaptured depreciation taxed as ordinary income

B

7) Initial cash outflows and subsequent operating cash inflows for a project are referred to as ________. A) necessary cash flows B) relevant cash flows C) perpetual cash flows D) ordinary cash flows

B

72) A firm is selling an existing asset for $5,000. The asset, when purchased, cost $10,000, was being depreciated under MACRS using a five-year recovery period and has been depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax effect of this transaction is ________. A) $0 tax liability B) $1,320 tax liability C) $1,160 tax liability D) $2,000 tax benefit

B

84) Which of the following would be used in the computation of an initial investment? A) the annual after-tax inflow expected from the investment B) the initial purchase price of the investment C) the historic cost of the existing investment D) the profits from the new investment

B

87) When evaluating a capital budgeting project, installation costs of a new machine must be considered as part of ________. A) the operating cash inflows B) the initial investment C) the incremental operating cash inflows D) the operating cash outflows

B

91) A corporation is considering expanding operations to meet growing demand. With the capital expansion the current accounts are expected to change. Management expects cash to increase by $10,000, accounts receivable by $20,000, and inventories by $30,000. At the same time accounts payable will increase by $40,000, accruals by $30,000, and long-term debt by $80,000. The change in net working capital is ________. A) an increase of $10,000 B) a decrease of $10,000 C) a decrease of $90,000 D) an increase of $80,000

B

28) The shares traded publicly in an efficient market are ________. A) generally positively affected by diversification, because of the reduction in risk B) generally negatively affected by diversification, because of the increase in risk C) generally not affected by diversification, unless greater returns are expected D) generally negatively affected by diversification, because of the increase in the required rate of return

C

62) The book value of an asset is equal to the ________. A) fair market value minus the accounting value B) original purchase price plus annual depreciation expense C) original purchase price minus accumulated depreciation D) depreciated value plus recaptured depreciation

C

64) The tax treatment regarding the sale of existing assets that are sold for more than the book value but less than the original purchase price results in a(n) ________. A) ordinary tax benefit B) capital gain tax liability C) recaptured depreciation taxed as ordinary income D) capital gain tax liability and recaptured depreciation taxed as ordinary income

C

67) The portion of an asset's sale price that is below its book value and below its initial purchase price is called ________. A) a capital gain B) recaptured depreciation C) a capital loss D) book value

C

7) When making replacement decisions, the development of relevant cash flows is complicated when compared to expansion decisions, due to the need to calculate ________ cash inflows. A) conventional B) opportunity C) incremental D) sunk

C

74) A corporation has decided to replace an existing asset with a newer model. Two years ago, the existing asset originally cost $30,000 and was being depreciated under MACRS using a five-year recovery period. The existing asset can be sold for $25,000. The new asset will cost $75,000 and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax rate is 40 percent on ordinary income and capital gains, the initial investment is ________. A) $42,000 B) $52,440 C) $54,240 D) $50,000

C

89) In evaluating the initial investment for a capital budgeting project, ________. A) an increase in net working capital is considered a cash inflow B) a decrease in net working capital is considered a cash outflow C) an increase in net working capital is considered a cash outflow D) net working capital does not have to be considered

C

94) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must estimate the terminal cash flow. The proposed machine will be disposed of at the end of its usable life of five years at an estimated sale price of $2,000. The machine has an original purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________. A) $5,800 B) $7,800 C) $8,200 D) $6,200

C

they do not need the firm to do it for them D) it is not possible for a firm to diversify its risk as the inflation premium is different for different projects

C

13) The ________ approach is used to convert the net present value of unequal-lived projects into an equivalent annual amount (in net present value terms). A) internal rate of return B) investment opportunities schedule C) risk-adjusted discount rate D) annualized net present value

D

19) An IRR approach to capital rationing involves graphically plotting project IRRs in descending order against total dollar investment on an ________ graph. A) ANPV B) NPV C) RADR D) IOS

D

22) In capital budgeting, risk refers to ________. A) the chance that a project will prove acceptable B) the conflicting IRR and NPV in a project C) the degree of variability of initial outlay D) the uncertainty of cash inflows

D

30) One type of simulation program made popular by the widespread use of personal computers is called ________. A) Monaco Simulation B) Lemans Simulation C) Cannes Simulation D) Monte Carlo Simulation

D

88) The change in net working capital when evaluating a capital budgeting decision is ________. A) the change in fixed liabilities minus the change in fixed assets B) the increase in current assets C) the increase in current liabilities D) the change in current assets minus the change in current liabilities

D

9) Cash outlays that had been previously made and have no effect on the cash flows relevant to a current decision are called ________. A) incremental historical costs B) incremental past expenses C) opportunity costs foregone D) sunk costs

D

90) A corporation is considering expanding operations to meet growing demand. With the capital expansion, the current accounts are expected to change. Management expects cash to increase by $20,000, accounts receivable by $40,000, and inventories by $60,000. At the same time accounts payable will increase by $50,000, accruals by $10,000, and long-term debt by $100,000. The change in net working capital is ________. A) an increase of $120,000 B) a decrease of $60,000 C) a decrease of $120,000 D) an increase of $60,000

D

92) If accounts receivable increase by $1,000,000, inventory decreases by $500,000, and accounts payable increase by $500,000, net working capital would ________. A) decrease by $500,000 B) increase by $1,500,000 C) increase by $2,000,000 D) experience no change

D

1) If a new asset is being considered as a replacement for an old asset, the relevant cash flows would be found by adding the operating cash flows from the old asset to the operating cash flows from the new asset.

FALSE

11) In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

FALSE

11) Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

FALSE

13) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintains a diversified portfolio of assets.

FALSE

15) Net working capital is the difference between a firm's total assets and its total liabilities.

FALSE

15) Sensitivity analysis is a statistics-based approach used in capital budgeting to asses risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

FALSE

17) In computing after-tax operating cash flows, both operating costs and financing costs must be deducted from any cash inflows received.

FALSE

17) Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

FALSE

2) The acceptance of a particular project usually has no impact on a firm's overall risk.

FALSE

3) All projects should always use the WACC as the required return for capital budgeting purposes.

FALSE

3) Under MACRS depreciation, the depreciable value of an asset is equal to the asset's purchase price minus any installation costs.

FALSE

3) When unequal-lived projects are independent, the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

FALSE

5) Behavioral approaches for dealing with risk include annualized net present values and risk-adjusted discount rates.

FALSE

6) In selecting the best group of unequal-lived projects, if the projects are mutually exclusive, the length of the projects lives is not critical.

FALSE

6) Recaptured depreciation is the portion of the sale price that is below the book value.

FALSE

3) Opportunity costs should be included as cash outflows when determining a project's incremental cash flows.

TRUE

Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects. Project P Q Init. Inv 40000 50000 Proj life 3 yr 3 yr Ann. Cshflow 15000 25000 Risk-adj disct 10% 14% Risk-free ror 6% 6% 30) Evaluate the projects using risk-adjusted discount rates. (See Table 11.9)

NPVP = (15,000/.1) × [1-1/(1.1)^3] - 40,000 = -$2,697 NPVQ= (25,000/.14) × [1-1/(1.14)^3] - 50,000 = $8,041 31) Which project do you recommend? (See Table 11.9) Answer: 30 NPVP = (15,000/.1) × [1-1/(1.1)^3] - 40,000 = -$2,697 NPVQ= (25,000/.14) × [1-1/(1.14)^3] - 50,000 = $8,041 31 Project P has a negative net present value using RADRs. Project Q has a positive NPV of $8,041 using RADRs. Project Q is recommended.

3) The relevant cash flows for a proposed capital expenditure are the incremental after-tax cash outflows and resulting subsequent inflows.

TRUE

11) Please explain the difference between a sunk cost and an opportunity cost and give an example of each type of cost.

Sunk costs are cash outlays that have already been made (past outlays) and cannot be recovered. Sunk costs have no effect on the cash flows relevant to the current decision. As a result, sunk costs should not be included in a project's incremental cash flows. Opportunity costs are cash flows that could be realized from the best alternative use of an asset that is already in place. They, therefore, represent cash flows that will not be realized as a result of employing that asset in the proposed project. Thus, any opportunity costs should be included as cash outflows when one is determining a project's incremental cash flows.

1) In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project results in an incorrect decision.

TRUE

1) To calculate the initial investment, we subtract all cash inflows occurring at time zero from all cash outflows occurring at time zero.

TRUE

10) If an asset is sold for more than its initial purchase price, the gain on the sale is composed of two parts: a capital gain and recaptured depreciation.

TRUE

10) In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a positive NPV and those falling below the SML would have a negative NPV.

TRUE

10) The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

TRUE

11) A firm with limited funds for investment in capital assets must ration those funds by allocating them to projects that will maximize share value.

TRUE

13) Scenario analysis is a behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number of variables.

TRUE

13) The change in net working capital—regardless of whether an increase or decrease—is not taxable because it merely involves a net buildup or net reduction of current accounts.

TRUE

14) If an investment in a new asset results in a change in current assets that exceeds the change in current liabilities, this change in net working capital represents an initial cash outflow.

TRUE

14) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses the variability of returns.

TRUE

16) RADRs are popular because they are consistent with the general disposition of financial decision makers toward rates of return.

TRUE

16) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

TRUE

18) In computing after-tax operating cash flows, only operating costs but not financing costs must be deducted from any cash inflows received.

TRUE

18) The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.

TRUE

19) In evaluating a proposed project, incremental operating cash inflows are relevant cash flows.

TRUE

19) Monte Carlo simulation programs usually build a histogram of the results.

TRUE

2) The basic cash flows that must be considered when determining the initial investment associated with a capital expenditure are the installed cost of the new asset, the after-tax proceeds (if any) from the sale of an old asset, and the change (if any) in net working capital.

TRUE

2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate a firm's owners adequately, that is, to maintain or improve the firm's share price.

TRUE

2) When unequal-lived projects are independent, the length of the project lives is not critical.

TRUE

3) A market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

TRUE

16) All benefits expected from a proposed project must be measured on a cash flow basis which may be found by adding any non-cash charges deducted as an expense on a firm's income statement back to net profits after taxes.

True