Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)
Chapter 9 Fundamentals of Capital Budgeting
9.1 The Capital Budgeting Process
1) A capital budget lists the potential projects a company may undertake in future years.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
2) Capital budgeting decisions use the Net Present Value rule so that those decisions
maximize net present value (NPV).
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
3) The capital budgeting process begins by ________.
A) analyzing alternate projects
B) evaluating the net present value (NPV) of each project’s cash lows
C) compiling a list of potential projects
D) forecasting the future consequences for the irm of each potential project
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
4) The ultimate goal of the capital budgeting process is to ________.
A) determine how the consequences of making a particular decision afects the irm’s
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 irm
D) determine the efect of the decision to accept or reject a project on the irm’s cash lows
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
1
5) Which of the following best deines incremental earnings?
A) cash lows arising from a particular investment decision
B) the amount by which a irm’s 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 ixed time
span
D) the net present value (NPV) of earnings that a irm is expected to receive as the result of
an investment decision
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6) Which of the following best describes why the predicted incremental earnings arising
from a given decision are not suicient in and of themselves to determine whether that
decision is worthwhile?
A) They do not tell how the decision afects the irm’s reported proits from an accounting
perspective.
B) They are not easily predicted from historical inancial statements of a irm and its
competitors.
C) These earnings are not actual cash lows.
D) They do not show how the irm’s earnings are expected to change as the result of a
particular decision.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
7) What is the correct tax rate that should be used for capital budgeting decisions?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
8) How do we handle interest expense when making a capital budgeting decision?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
2
9.2 Forecasting Incremental Earnings
1) When evaluating the efectiveness of an improved manufacturing process we should
evaluate the total sales and costs generated by this process.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
2) Interest and other inancing-related expenses are excluded when determining a project’s
unlevered net income.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3) Cameron Industries is purchasing a new chemical vapor depositor in order to make
silicon chips. It will cost $6 million 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 have a working life of six years. Which of these
activities will be reported as an operating expense?
A) the delivery and install cost only
B) the cost of the depositor only
C) the redesign of the plant only
D) the delivery and install cost and the cost of the depositor
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3
4) Cameron Industries is purchasing a new chemical vapor depositor in order to make
silicon chips. It will cost $4 million to buy the machine and $12,000 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 have a working life of six years. If straight-line
depreciation is used, what are the yearly depreciation expenses in this case?
A) $666,667
B) $668,667
C) $1,166,667
D) $1,168,667
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
5) An oil company is buying a semi-submersible oil rig for $15 million. Additionally, it will
cost
$1.5 million to move the oil rig to the oil-ield and to prepare it for operations. If it is
depreciated over ive years using straight-line depreciation, what are the yearly
depreciation expenses in this case?
A) $2.7 million
B) $3.0 million
C) $3.3 million
D) $3.8 million
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
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 luctuations 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 proit margins over time in most industries
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
4
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 reconigure 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 irm 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-Nelson’s
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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
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 ive years with production and support costs of $1.5
million per year. If CathFood’s 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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
5
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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10) Which of the following is NOT a factor that a manager should bear in mind when
estimating a project’s 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 inlation in the economy.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6
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 proit margin for the new ginger ale is 40%, the gross proit
margin of all of the brewer’s other products is 30%, and the brewer’s 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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
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 efect
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 efect on taxes.
D) It will reduce taxes by $2.8 million.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Previous Edition
7
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 irm 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.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
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 lows of a project, inancial
managers often begin by forecasting earnings.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
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) ixed overhead cost
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
8
16) 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 $35 million next year. Without the new SUV, Ford expects to earn pre-
tax income of $80 million from operations next year. Ford pays a 35% tax rate on its pre-tax
income. The amount that Ford Motor Company owes in taxes next year without the launch
of the new SUV is closest to ________.
A) $28.0 million
B) 12.3 million
C) $40.3 million
D) $15.8 million
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
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
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
9
18) Food For Less (FFL), a grocery store, is considering ofering one-hour photo developing
in their store. The irm expects that sales from the new one-hour machine will be $175,000
per year. FFL currently ofers overnight ilm 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
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
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 irm is in the 35% tax bracket and has a cost of capital of 10%.
The depreciation tax shield for the Sisyphean Corporation’s project in the irst year is
closest to ________.
A) $10,500
B) $3500
C) $3150
D) $2800
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
10