2) In 2010, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of
10%, while inflation will increase both the sales price and the cost per unit by 3%. In real dollars,
expected gross profit for 2011 is:
A) $40 million.
B) $45.32 million.
C) $48.2 0 million.
D) $50 million.
Topic: 12.3 Inflation and Capital Budgeting
Keywords: nominal cash flows
Principles: Principle 3: Cash Flows Are the Source of Value
3) In 2010, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of
10%, Inflation will increase the cost per unit by 3%, but to attract more buyers, Sunny will
reduce the price by 5%. In real dollars, expected gross profit for 2011 is:
A) $45.32 million.
B) $40 million.
C) $38 million.
D) $36.52 million.
Topic: 12.3 Inflation and Capital Budgeting
Keywords: nominal cash flows
Principles: Principle 3: Cash Flows Are the Source of Value
4) Greenspan Inc. discounts cash flows at a nominal rate of 10%. Inflation over the next few
years is expected to average 3%. Which of the following would be a correct adjustment for
inflation when computing net present value?
A) Discount cash flows at 10%; increase revenues and expenses by 3% each year.
B) Discount cash flows at 13%; increase revenues and expenses by 3% each year.
C) Discount cash flows at 7%; ignore inflation when forecasting revenues and expenses.
D) Either A or C would be acceptable.
Topic: 12.3 Inflation and Capital Budgeting
Keywords: nominal cash flows
Principles: Principle 3: Cash Flows Are the Source of Value
28
5) What is meant by “real dollars” and the “real” discount rate? How can they be used to account
for inflation when evaluating capital budgeting proposals?
Topic: 12.3 Inflation and Capital Budgeting
Keywords: nominal cash flows
Principles: Principle 3: Cash Flows Are the Source of Value
6) Tversky and Co. have devised a new psychological test for investors’ risk tolerance. They
expect to sell 10,000 tests in the first year at $150 each. Cash costs associated with producing,
administering and scoring the test are $50 per unit. In the second year, volume is expected to be
the same, but both the price and the costs will increase 2.5%. Forecast gross profit in the second
year.
Topic: 12.3 Inflation and Capital Budgeting
Keywords: nominal cash flows
Principles: Principle 3: Cash Flows Are the Source of Value
29
12.4 Replacement Project Cash Flows
Use the following information to answer the following question(s).
1) If the new machine is purchased, depreciation expense will increase or decrease by:
A) increase $8,000
B) increase $6,900
C) Increase $6,300
D) decrease $5,000
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
2) Increased taxes on the sale of the old machine are:
A) $1,487.50.
B) $2,500.50.
C) $3,823.50.
D) $4,312.50.
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
30
3) If the new machine is purchased, operating cash flow for years 1 through 5 will increase or
decrease by:
A) $15,000.
B) $9,900.
C) $12,246.
D) $5,346.
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
4) What would cause the initial cash outlay of an investment decision to be affected by the sale
of an existing asset?
A) If the investment decision is a replacement decision
B) If the asset being purchased is technologically superior
C) If the asset being sold has exceeded its MACR’s recovery allowance period
D) All of the above
E) None of the above
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
5) Al’s Fabrication Shop is purchasing a new rivet machine to replace an existing one. The new
machine costs $8,000 and will require an additional cost of $1,000 for modification and training.
It will be depreciated using simplified straight line depreciation over five years. The new
machine operates much faster than the old machine and with better quality. Consequently, sales
are expected to increase by $2,100 per year for the next five years. While it is faster, it is fully
automated and will result in increased electricity costs for the firm by $700 per year. It will,
however, save about $850 per year in labor costs. The old machine is 20 years old and has
already been fully depreciated. If the firm’s marginal tax rate is 28%, compute the after tax
incremental cash flows for the new machine for years 1 through 5.
A) $2,698
B) $450
C) $2,124
D) $1,620
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
31
6) National Geographic is replacing an old printing press with a new one. The old press is being
sold for $350,000 and it has a net book value of $75,000. Assume that National Geographic is in
the 40% income tax bracket. How much will National Geographic pay in income taxes from the
sale?
A) $140,000
B) $45,000
C) $110,000
D) $87,010
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
7) Krugman Construction Company is considering the purchase of a new crane at a cost of
$600,000. If the new crane is purchased the old crane will sold. It was purchased 5 years ago at a
cost of $450,000. To date, the company has taken $200,000 in depreciation on the old crane.
Compute the cash flow that would be realized from selling the old crane under each of the
following scenarios. Krugman’s marginal tax rate is 30%.
a. The crane is sold for $200,000
b. The crane is sold for $250,000
c. The crane is sold for $300,000
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
32
8) Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy
10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years
with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. If the old
oven is sold for $10,000, compute the net cost of the new oven.
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
9) Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy
10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years
with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. Compute:
a. the change in annual depreciation that would result from purchasing the new machine.
b. the change in taxes each year that would result from purchasing the new machine.
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
33
10) Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly
line will be fully depreciated by the simplified straight line method over its 5 year depreciable
life. Operating costs of the new machine are expected to be $1,100,000 per year. The existing
assembly line has 5 years remaining before it will be fully depreciated and has a book value of
$3,000,000. If sold today the company would receive $2,400,000 for the existing machine.
Annual operating costs on the existing machine are $2,100,000 per year. Bull Gator is in the 46
percent marginal tax bracket and has a required rate of return of 12 percent.
a. Calculate the net present value of replacing the existing machine.
b. Explain the impact on NPV of the following:
i. Required rate of return increases
ii. Operating costs of new machine are increased
iii. Existing machine sold for less
Topic: 12.4 Replacement Project Cash Flows
Keywords: replacement investment
Principles: Principle 3: Cash Flows Are the Source of Value
34