FIN CH 9: FUNDAMENTALS OF CAPITAL BUDGETING
10) A company buys tracking software for its warehouse which, along with the computer system and ancillaries to run it, will cost $1.6 million. This purchase will be deducted over five years. It is expected that the software will reduce inventory by $10.7 million at the end of the first year after it is installed, though there will be an annual cost of $120,000 per year to run the system. If the companyʹs marginal tax rate is 40%, how will the purchase of this item change the companyʹs free cash flows in the first year? A) $10.756 million B) $10.380 million C) $9.680 million D) $11.832 million
A
11) A brewer is launching a new product: brewed ginger ale with a low alcohol content. The brewer plans to spend $4 million promoting this product this year, which is expected to expand the sales of this product to $11 million this year and $8 million next year. They do expect there will be loss of sales of $1 million this year and next year in their other products as customers switch to drinking the new ginger ale. The gross profit margin for the new ginger ale is 40%, the gross profit margin of all of the brewerʹs other products is 30%, and the brewerʹs marginal corporate tax rate is 35%. What are incremental earnings arising from the promotional campaign this year? A) $1.625 million B) $1.26 million C) $2.11 million D) $4.40 million
A
13) Year 0 Year 1 Year 2 Year 3 Revenues 363,688.342 363,688.342 363,688.342 - Cost of Goods Sold -150,000 -150,000 -150,000 - Depreciation -80,000 -80,000 -80,000 = EBIT 133,688.342 133,688.342 133,688.342 - Taxes (35%) -46,790.9196 - 46,790.9196 - 46,790.9196 = Unlevered net income 86,897.4221 86,897.4221 86,897.4221 + Depreciation 80,000 80,000 80,000 - Additions to Net Working Capital -20,000 -20,000 -20,000 - Capital Expenditures -300,000 = Free Cash Flow 146,897.422 146,897.422 146,897.422 Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive research, they come up with the above estimates of free cash flow from this project. By how much could the discount rate rise before the net present value (NPV) of this project is zero, given that it is currently 10%? A) 12% B) 17% C) 27% D) 22%
A
13) Your firm is considering building a new office complex. Your firm already owns land suitable for the new complex. The current book value of the land is $130,000 ; however, a commercial real estate agent has informed you that an outside buyer is interested in purchasing this land would be willing to pay $700,000 for it. When calculating the net present value (NPV) of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is ________. A) $700,000 B) $0 C) $130,000 D) $830,000
A
15) Which of the following statements is FALSE? A) The break-even level of an input is the level for which the investment has an internal rate of return (IRR) of zero. B) The most difficult part of capital budgeting is deciding how to estimate the cash flows and the cost of capital. C) When evaluating a capital budgeting project, financial managers should make the decision that maximizes net present value (NPV). D) Sensitivity analysis reveals those aspects of the project which are most critical when we are actually managing the project.
A
15) You are considering adding a microbrewery onto one of your firmʹs existing restaurants. This will entail an investment of $47,000 in new equipment. This equipment will be depreciated straight-line over five years. If your firmʹs marginal corporate tax rate is 35%, then what is the value of the microbreweryʹs depreciation tax shield in the first year of operation? A) $3290 B) $16,450 C) $6110 D) $30,550
A
17) Ford Motor Company is considering launching a new line of hybrid diesel-electric SUVs. The heavy advertising expenses associated with the new SUV launch would generate operating losses of $30 million next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next year. Ford pays a 30% tax rate on its pre-tax income. The amount that Ford Motor Company owes in taxes next year with the launch of the new SUV is closest to ________. A) $15.0 million B) $9.0 million C) $33.0 million D) $24.0 million
A
17) The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2500 canes in year 1. Sales are estimated to grow by 9% each year through year 3. The price per cane that Sisyphean will charge its customers is $16 each and is to remain constant. The canes have a cost per unit to manufacture of $10 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 3% of its annual sales in cash, 5% of its annual sales in accounts receivable, 10% of its annual sales in inventory, and 5% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a cost of capital of 9%. The required net working capital in the first year for the Sisyphean Corporationʹs project is closest to ________. A) $5200 B) $5668 C) -$2800 D) $9200
A
18) Food For Less (FFL), a grocery store, is considering offering one-hour photo developing in their store. The firm expects that sales from the new one-hour machine will be $175,000 per year. FFL currently offers overnight film processing with annual sales of $90,000 . While many of the one-hour photo sales will be to new customers, FFL estimates that 40% of their current overnight photo customers will switch and use the one-hour service. The level of incremental sales associated with introducing the new one hour photo service is closest to ________. A) $139,000 B) $175,000 C) $36,000 D) $70,000
A
2) Jim owns a farm that he wants to sell. He learns that a highway will be built near the farm in the future, giving access to the farmland from a nearby city and thus making the land attractive to housing developers. Expecting the net present value (NPV) of the sale to be greater after the highway is built, he decides not to sell at this time. What real option is Jim taking? A) option to delay B) option to expand C) option to abandon D) option to switch
A
21) Which of the following is an example of cannibalization? A) A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product line. B) A grocery store begins selling T-shirts featuring the local universityʹs mascot. C) A basketball manufacturer adds basketball hoops to its product line. D) A convenience store begins selling pre-paid cell phones.
A
22) Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $5 million to set up and will generate $21 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $8 million during this year and depreciation expense will be another $2 million. THSI will require no working capital for this investment. THSIʹs marginal tax rate is 35% Assume that THSIʹs cost of capital for this project is 15%. The net present value (NPV) of this temporary housing project is closest to ________. A) $2,956,522 B) -$9.15 C) $5,913,044 D) -$2,956,522
A
26) Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3 Sales (Revenues) $150,000 $150,000 $150,000 - Cost of Goods Sold (50% of Sales) 75,000 75,000 75,000 - Depreciation 20,000 20,000 20,000 = EBIT 55,000 55,000 55,000 - Taxes (35%) 19,250 19,250 19,250 = unlevered net income 35,750 35,750 35,750 + Depreciation 20,000 20,000 20,000 +/(-) increase/(decrease) in working capital 5,000 5,000 -10,000 - capital expenditures -$90,000 The free cash flow for the last year of Epiphanyʹs project is closest to ________. A) $65,750 B) $59,175 C) $49,313 D) $52,600
A
3) The term ʺcannibalizationʺ refers to ________. A) decrease in the sales of current project caused by the launching of new project B) decrease in the sunk cost caused by launching of new project C) decrease in overhead expenses incurred due to launch of new project D) cost of using a resource for the best value it could provide in its best alternative
A
4) A company spends $20 million researching whether it is possible to create a durable plastic from the process waste from feedstock preparation. The $20 million should best be considered ________. A) as a sunk cost B) as an opportunity cost C) as a fixed overhead expense D) as a capital cost
A
5) Joe pre-orders a non-refundable movie ticket. He then reads a number of reviews of the movie in question that make him realize that he will not enjoy it. He goes to see it anyway, rationalizing that otherwise his money will have been wasted. Is Joe succumbing to the Sunk Cost Fallacy, and why? A) Yes, since he invested a valuable asset, his time, in a project based on its previous costs. B) No, because the cost of the movie was not recoverable and would have been lost whatever action he took. C) No, because going to see the movie means that the product of his initial investment was realized as originally planned. D) Yes, because he incurred no further costs by going to see the movie.
A
6) Cameron Industries is purchasing a new chemical vapor depositor in order to make silicon chips. It will cost $6,000,000 to buy the machine and $20,000 to have it delivered and installed. Building a clean room in the plant for the machine will cost an additional $3 million. The machine is expected to raise gross profits by $4,000,000 per year, starting at the end of the first year, with associated costs of $1 million for each of those years. The machine is expected to have a working life of five years and will be depreciated over those five years. The marginal tax rate is 40%. What are the incremental free cash flows associated with the new machine in year 0? A) -$6,020,000 B) -$6,000,000 C) -$5,418,000 D) $1,204,000
A
6) Which of the following is usually NOT a factor that must be considered when estimating the revenues and costs arising from a new product? A) the fluctuations in the cost of capital over the period in question B) the sales of a new product will typically accelerate, plateau, and ultimately decline over time C) the prices of technology products generally fall over time D) competition tends to reduce profit margins over time in most industries
A
7) CathFoods will release a new range of candies which contain antioxidants. New equipment to manufacture the candy will cost $2 million, which will be depreciated by straight-line depreciation over four years. In addition, there will be $5 million spent on promoting the new candy line. It is expected that the range of candies will bring in revenues of $4 million per year for four years with production and support costs of $1.5 million per year. If CathFoodʹs marginal tax rate is 35%, what are the incremental free cash flows in the second year of this project? A) $1.800 million B) $1.400 million C) $2.000 million D) $0.700 million
A
7) Which of the following is an example of cannibalization? A) A toothpaste manufacturer adds a new line of toothpaste (that contains baking soda) to its product line. B) A grocery store begins selling T-shirts featuring the local universityʹs mascot. C) A basketball manufacturer adds basketball hoops to its product line. D) A convenience store begins selling pre-paid cell phones.
A
8) CathFoods will release a new range of candies which contain anti-oxidants. New equipment to manufacture the candy will cost $4 million, which will be depreciated by straight-line depreciation over six years. In addition, there will be $5 million spent on promoting the new candy line. It is expected that the range of candies will bring in revenues of $6 million per year for five years with production and support costs of $1.5 million per year. If CathFoodʹs marginal tax rate is 35%, what are the incremental earnings in the second year of this project? A) $2.492 million B) $2.100 million C) $3.833 million D) $1.342 million
A
9) The manufacturer of a brand of kitchen knives is investigating the likely effects that an increase in the cost of the raw materials required to make these knives will have on the cost of manufacturing the knives, the selling price of the knives, the number of knives that will then be sold, and the projectʹs net present value (NPV). Which of the following best describes what type of analysis the manager is performing? A) scenario analysis B) sensitivity analysis C) break-even analysis D) EBIT-break even analysis
A
22) How are the taxes paid under MACRS different from that paid under straight -line depreciation?
Answer: We are not paying less in taxes when using MACRS, but it is the timing of the tax payment that is different.
10) Which of the following is NOT a factor that a manager should bear in mind when estimating a projectʹs revenues and costs? A) Sales of a product will typically accelerate, stabilize, and then decline as the product becomes outdated or faces increased competition. B) A new product typically has its highest sales immediately after release as customers are attracted by the novelty of the product. C) The prices of technology products tend to fall over time as newer, superior technologies emerge and production costs decline. D) Prices and costs tend to rise with the general level of inflation in the economy
B
11) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 MACRS Depreciation Rate 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% 4.46% Massive Amusements, an owner of theme parks, invests $65 million to build a roller coaster. This can be depreciated using the MACRS schedule shown above. How much less is the depreciation tax shield for year 4 under MACRS depreciation than under 7 -year, straight-line depreciation, if the tax rate is 35%? A) $974,680 B) $1,218,350 C) $2,193,030 D) $6,091,750
B
14) Which of the following statements is FALSE? A) Many projects use a resource that the company already owns. B) When evaluating a capital budgeting decision, we generally include interest expense. C) Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings
B
15) Which of the following costs would you consider when making a capital budgeting decision? A) sunk cost B) opportunity cost C) interest expense D) fixed overhead cost
B
16) The Sisyphean Company is considering a new project that will have an annual depreciation expense of $3.6 million. If Sisypheanʹs marginal corporate tax rate is 35% and its average corporate tax rate is 30%, then what is the value of the depreciation tax shield on the companyʹs new project? A) $1,080,000 B) $1,260,000 C) $1,890,000 D) $1,134,000
B
19) The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2000 canes in year 1. Sales are estimated to grow by 10% per year each year through year 3. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 5% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a cost of capital of 10%. The depreciation tax shield for the Sisyphean Corporationʹs project in the first year is closest to ________. A) $10,500 B) $3500 C) $3150 D) $2800
B
20) Bubba Ho-Tep Company reported net income of $290 million for the most recent fiscal year. The firm had depreciation expenses of $100 million and capital expenditures of $150 million. Although it had no interest expense, the firm did have an increase in net working capital of $30 million. What is Bubba Ho-Tepʹs free cash flow? A) $10 million B) $210 million C) $270 million D) $570 million
B
20) Which of the following would you NOT consider when making a capital budgeting decision? A) the additional taxes a firm would have to pay in the next year B) the cost of a marketing study completed last year C) the opportunity to lease out a warehouse instead of using it to house a new production line D) the change in direct labor expense due to the purchase of a new machine
B
30) A firm is considering investing in a new machine that will cost $400,000 and will be depreciated straight-line over five years. If the firmʹs marginal tax rate is 39%, what is the annual depreciation tax shield of purchasing the machine? A) $80,000 B) $31,200 C) $28,080 D) $156,000
B
4) A manufacturer of peripheral devices for PCs decides to try and capture some of the PC gaming market by creating gaming versions of its traditional peripheral devices. It decides to start with a gaming version of its standard keyboard, increasing the number of macro keys, adding a small LCD screen to display game data, and giving the user the ability to backlight keys in different colors. If this device is a success, the manufacturer plans to release gaming versions of its trackballs and other peripherals. What option is the manufacturer gaining by the release of the new keyboard? A) option to delay B) option to expand C) option to abandon D) option to switch
B
5) Which of the following best defines incremental earnings? A) cash flows arising from a particular investment decision B) the amount by which a firmʹs earnings are expected to change as a result of an investment decision C) the earnings arising from all projects that a company plans to undertake in a fixed time span D) the net present value (NPV) of earnings that a firm is expected to receive as the result of an investment decision
B
5) Which of the following formulas will correctly calculate Net Working Capital? A) Cash + Inventory + Receivables + Payables B) Cash + Inventory + Receivables - Payables C) Cash + Inventory - Receivables + Payables D) Cash - Inventory + Receivables + Payables
B
5) Which of the following statements regarding real options is NOT correct? A) Real options should only be exercised when they increase the NPV of a project. B) Real options enhance the forecast of a projectʹs expected future cash flows by incorporating, at the start of the project, the effect of decisions that will be made at a later date. C) Real options give owners the right, but not the obligation, to exercise these opportunities at a later date. D) Real options build greater flexibility into a project and thus increase its net present value (NPV).
B
7) Vernon-Nelson Chemicals is planning to release a new brand of insecticide, Bee-Safe, that will kill many insect pests but not harm useful pollinators. Buying new equipment to manufacture the product will cost $15 million, and there will be an additional $2 million cost to reconfigure existing plant. The equipment is expected to have a lifetime of nine years and will be depreciated by the straight-line method over its lifetime. The firm expects that they should be able to sell 1,500,000 gallons per year at a price of $53 per gallon. It will take $36 per gallon to manufacture and support the product. If Vernon-Nelsonʹs marginal tax rate is 40%, what are the incremental earnings after tax in year 3 of this project? A) $25.5 million B) $14.3 million C) $23.8 million D) $9.5 million
B
9) A firm reports that in a certain year it had a net income of $5.0 million, depreciation expenses of $3.0 million, capital expenditures of $2.0 million, and Net Working Capital decreased by $1.1 million. What is the firmʹs free cash flow for that year? A) $11.1 million B) $7.1 million C) $5.1 million D) $4.9 million
B
11) Revenues Cost of Goods Sold Year 0 Year 1 700,000 -320,000 Year 2 700,000 -320,000 Year 3 700,000 -320,000 Gross Profit Selling, General and Admin Depreciation 380,000 -105,000 -190,000 380,000 -105,000 -190,000 380,000 -105,000 -190,000 EBIT Income tax (35%) 85,000 -29,750 85,000 -29,750 85,000 -29,750 Incremental Earnings Capital Purchases Changes to NWC -600,000 55,250 -12,000 55,250 -12,000 55,250 -12,000 Cromwell Industries is considering a new project which will have costs, revenues, etc. as shown by the data above. If the cost of capital is 8.0%, what is the net present value (NPV) of this project? A) -$56,662 B) -$59,810 C) $62,958 D) $69,254
C
13) Which of the following statements is FALSE? A) We begin the capital budgeting process by determining the incremental earnings of a project. B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax income. C) Investments in plant, property, and equipment are directly listed as expense when calculating earnings. D) The opportunity cost of using a resource is the value it could have provided in its best alternative use.
C
25) Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 +/(-) increase/(decrease) in working capital 5,000 5,000 5,000 - capital expenditures -90,000 The free cash flow for the first year of Epiphanyʹs project is closest to ________. A) $45,600 B) $28,500 C) $38,000 D) $53,200
C
27) Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3 Sales (Revenues) 150,000 150,000 150,000 - Cost of Goods Sold (50% of Sales) 75,000 75,000 75,000 - Depreciation 25,000 25,000 25,000 = EBIT 50,000 50,000 50,000 - Taxes (35%) 17,500 17,500 17,500 = unlevered net income 32,500 32,500 32,500 + Depreciation 25,000 25,000 25,000 +(-) increase/(decrease) in working capital 5,000 5,000 -10,000 - capital expenditures -90,000 The net present value (NPV) for Epiphanyʹs Project is closest to ________. A) $23,387 B) $140,319 C) $46,773 D) $93,546
C
3) After research into where to place a new restaurant, Burger Billies, a small fast-food chain, plans to open a new store near a small college. The anticipated customer base is students attending the college. They learn that a major fast food chain will be opening a franchise within the college, which leads the owners of Burger Billies to revise their estimate of sales to one below the break-even point. Which of the following is most likely the best real option for Burger Billies to take with regard to the proposed restaurant site? A) option to delay B) option to expand C) option to abandon D) option to switch
C
3) The capital budgeting process begins by ________. A) analyzing alternate projects B) evaluating the net present value (NPV) of each projectʹs cash flows C) compiling a list of potential projects D) forecasting the future consequences for the firm of each potential project
C
31) A firm is considering a new project that will generate cash revenue of $1,300,000 and cash expenses of $700,000 per year for five years. The equipment necessary for the project will cost $300,000 and will be depreciated straight line over four years. What is the expected free cash flow in the second year of the project if the firmʹs marginal tax rate is 35%? A) $374,625 B) $341,250 C) $416,250 D) $499,500
C
4) Cameron Industries is purchasing a new chemical vapor depositor in order to make silicon chips. It will cost $5,000,000 to buy the machine and $10,000 to have it delivered and installed. Building a clean room in the plant for the machine will cost an additional $3 million. The machine is expected to raise gross profits by $4,500,000 per year, starting at the end of the first year, with associated costs of $1 million for each of those years. The machine is expected to have a working life of six years and will be depreciated over those six years. The marginal tax rate is 40%. What are the incremental free cash flows associated with the new machine in year 2? A) $835,000 B) $2,665,000 C) $2,434,000 D) $831,667
C
6) Which of the following best describes why the predicted incremental earnings arising from a given decision are not sufficient in and of themselves to determine whether that decision is worthwhile? A) They do not tell how the decision affects the firmʹs reported profits from an accounting perspective. B) They are not easily predicted from historical financial statements of a firm and its competitors. C) These earnings are not actual cash flows. D) They do not show how the firmʹs earnings are expected to change as the result of a particular decision.
C
8) Balance Sheet Assets Liabilities Current Assets Current Liabilities Cash $47 Accounts payable $40 Accounts receivable 23 Total current liabilities 40 Inventories 16 Total current assets 86 Long-Term Assets Long-Term Liabilities Net property, plant, and equipment 164 Long-term debt 170 Total long-term assets 164 Total long-term liabilities 170 Total Assets 250 Total Liabilities 210 Stockholdersʹ Equity 40 Total Liabilities and Stockholdersʹ Equity 250 The balance sheet for a small firm is shown above. All amounts are in thousands of dollars. What is this firmʹs Net Working Capital? A) $126 thousand B) $7 thousand C) $46 thousand D) $86 thousand
C
9) A small manufacturer that makes clothespins and other household products buys new injection molding equipment for a cost of $500,000. This will allow the manufacturer to make more clothespins in the same amount of time with an estimated increase in sales of 25%. If the manufacturer currently makes 75 tons of clothespins per year, which sell at $18,000 per ton, what will be the increase in revenue next year from the new equipment? A) $125,000 B) $303,750 C) $337,500 D) $837,500
C
10) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 MACRS Depreciation Rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% A bakery invests $40,000 in a light delivery truck. This was depreciated using the five-year MACRS schedule shown above. If the company sold it immediately after the end of year 2 for $21,000 , what would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%? A) $11,520 B) $9480 C) $3792 D) $17,208
D
12) Revenues Cost of Goods Sold Year 0 Year 1 140,000 -70,000 Year 2 440,000 220,000 Year 3 440,000 220,000 Year 4 350,000 175,000 Gross Profit Selling, General and Admin Depreciation 70,000 -6400 -75,000 220,000 6400 75,000 220,000 6400 75,000 175,000 6400 75,000 EBIT Income tax (35%) -11,400 3990 138,600 -48,510 138,600 -48,510 93,600 -32,760 Incremental Earnings Capital Purchases Changes to NWC -280,000 -7410 -5,000 90,090 -5,000 90,090 -5,000 60,840 -5,000 A garage is installing a new ʺbubble-washʺ car wash. It will promote the car wash as a fun activity for the family, and it is expected that the novelty of this approach will boost sales in the medium term. If the cost of capital is 10%, what is the net present value (NPV) of this project? A) -$135,493 B) -$143,021 C) $165,603 D) $150,548
D
12) A stationery company plans to launch a new type of indelible ink pen. Advertising for the new product will be heavy and will cost the company $8 million, although the company expects general revenues of $280 million next year from sources other than sales of the new pen. If the company has a corporate tax-rate of 35% on its pretax income, what effect will the advertising for the new pen have on its taxes? A) It will increase taxes by $8 million. B) It will increase taxes by $2.8 million. C) It will have no effect on taxes. D) It will reduce taxes by $2.8 million.
D
13) Which of the following best explains why is it sensible for a firm to use an accelerated depreciation schedule such as MACRS rather than straight-line depreciation? A) The firm will substantially decrease its depreciation tax shield across all of the depreciation timeline. B) The firm can decide over how many years an item may be depreciated, thus allowing it full control of its depreciation expenses. C) The firm will have substantially fewer depreciation expenses later in the depreciation timeline. D) The firm will receive greater benefits to its cash flow earlier in the depreciation timeline and thus increase net present value (NPV).
D
14) You are considering adding a microbrewery onto one of your firmʹs existing restaurants. This will entail an increase in inventory of $8700 , an increase in accounts payables of $2300 , and an increase in property, plant, and equipment of $48,000 . All other accounts will remain unchanged. The change in net working capital resulting from the addition of the microbrewery is ________. A) $54,400 B) $11,000 C) $7680 D) $6400
D
16) Which of the following statements is FALSE? A) Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our net present value (NPV) analysis for the project. B) To compute the net present value (NPV) for a project, you need to estimate the incremental cash flows and choose a discount rate. C) Estimates of the cash flows and cost of capital are often subject to significant uncertainty. D) When we are certain regarding the input to a capital budgeting decision, it is often useful to determine the break-even level of that input.
D
17) Which of the following statements is FALSE? A) We can use scenario analysis to evaluate alternative pricing strategies for our project. B) Scenario analysis considers the effect on net present value (NPV) of changing multiple project parameters. C) The difference between the internal rate of return (IRR) of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. D) Scenario analysis breaks the net present value (NPV) calculation into its component assumptions and shows how the net present value (NPV) varies as each one of the underlying assumptions changes.
D
21) Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $6 million to set up and will generate $22 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $11 million during this year and depreciation expense will be another $2 million. THSI will require no working capital for this investment. THSIʹs marginal tax rate is 35%. Ignoring the original investment of $5 million, what is THSIʹs free cash flow for the first and only year of operation? A) $6.00 million B) $3.85 million C) $9.81 million D) $7.85 million
D
23) Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management has projected the project will produce the following cash flows for the first two years (in millions). Year 1 2 Revenues 1050 1425 Operating expense 375 550 Depreciation 230 280 Increase in working capital 50 80 Capital expenditures 270 320 Marginal corporate tax rate 30% 30% The depreciation tax shield for Shepard Industries project in year 1 is closest to ________. A) $84 million B) $104 million C) $83 million D) $69 million
D
28) Luther Industries has outstanding tax loss carryforwards of $72 million from losses over the past four years. If Luther earns $15 million per year in pre-tax income from now on, in how many years will Luther first pay taxes? A) 7 years B) 2 years C) 4 years D) 5 year
D
29) A firm is considering changing their credit terms. It is estimated that this change would result in sales increasing by $1,600,000 . This in turn would cause inventory to increase by $125,000 , accounts receivable to increase by $100,000 , and accounts payable to increase by $90,000 . What is the firmʹs expected change in net working capital? A) $1,735,000 B) $315,000 C) $225,000 D) $135,000
D
3) Which of the following adjustments should NOT be made when computing free cash flow from incremental earnings? A) adding depreciation B) adding all non-cash expenses C) subtracting increases in Net Working Capital D) subtracting depreciation expenses from taxable earnings
D
4) The ultimate goal of the capital budgeting process is to ________. A) determine how the consequences of making a particular decision affects the firmʹs revenues and costs B) list the projects and investments that a company plans to undertake in the future C) forecast the consequences of a list of future projects for the firm D) determine the effect of the decision to accept or reject a project on the firmʹs cash flows
D
6) An insurance office owns a large building downtown. The sixth floor of this building currently houses its entire Human Resources Department. After carrying out a survey to see whether the sixth floor could be rented and for what price, the company must decide whether to split the Human Resources Department between currently unoccupied spaces on several floors and rent out the entire sixth floor or to leave things as they currently are. Which of the following should NOT be considered when deciding whether to rent out the sixth floor? A) the amount obtained by renting the sixth floor B) the cost of refurbishing the new space to be occupied by the Human Resources Department C) cost involved with a loss of efficiency resulting from the Human Resources Department being split between several spaces D) the cost of the research into the feasibility of renting the sixth floor
D
7) A maker of computer games expects to sell 475,000 games at a price of $48 per game. These units cost $10 to produce. Selling, general, and administrative expenses are $1.0 million and depreciation is $280,000 . What is the EBIT break-even point for the number of games sold in this case?
D
8) Year 0 Year 1 Year 2 Year 3 MACRS Depreciation Rate 33.33% 44.45% 14.81% 7.41% A fast-food company invests $2.2 million to buy machines for making slurpees. These can be depreciated using the MACRS schedule shown above. If the cost of capital is 10%, what is the increase in the net present value (NPV) of the product gained by using MACRS depreciation over straight-line depreciation for three years? A) $28,559 B) $47,599 C) $76,158 D) $190,321
D
8) A maker of kitchenware is planning on selling a new chef-quality kitchen knife. The manufacturer expects to sell 1.6 million knives at a price of $120 each. These knives cost $80 each to produce. Selling, general, and administrative expenses are $500,000. The machinery required to produce the knives cost $1.4 million, depreciated by straight-line depreciation over five years. The maker determines that the EBIT break-even point for units sold and sale price is less than these estimates and that the EBIT break-even point for costs per unit, SG&A, and depreciation are greater than these estimates, so decides to go ahead with manufacturing the knife. Was this the correct decision? A) No, since the cost per unit should be greater than the EBIT break-even point for cost of goods if the project is to have a positive EBIT. B) Yes, since if the estimates for each parameter are correct , the EBIT will be positive. C) Yes, since a positive EBIT ensures that the project will have a positive net present value (NPV). D) It cannot be determined whether the decision was correct, since other factors contributing to the projectʹs net present value (NPV), such as the upfront investment, have not been included in the analysis.
D
9) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 MACRS Depreciation Rate 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% 4.46% A textile company invests $10 million in an open-end spinning machine. This was depreciated using the seven-year MACRS schedule shown above. If the company sold it immediately after the end of year 3 for $7 million, what would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%? A) $1,550,400 B) $3,124,000 C) $3,876,000 D) $5,449,600
D
1) When evaluating the effectiveness of an improved manufacturing process we should evaluate the total sales and costs generated by this process.
FALSE
2) Capital budgeting decisions use the Net Present Value rule so that those decisions maximize net present value (NPV).
FALSE
2) Interest and other financing-related expenses are excluded when determining a projectʹs unlevered net income.
TRUE
