33) What are project externalities?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
34) What are sunk costs?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
9.4 Other Efects on Incremental Free Cash Flows
1) Firms should use the most accelerated depreciation scheme allowable.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
2) An announcement by the government that they will decrease corporate marginal tax
rates in the future would increase the attractiveness of MACRS depreciation.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
3) The term “cannibalization” 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
AACSB Objective: Analytic Skills
Author: JN
Question Status: Revised
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 ixed overhead expense
D) as a capital cost
31
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
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.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
6) An insurance oice owns a large building downtown. The sixth loor of this building
currently houses its entire Human Resources Department. After carrying out a survey to
see whether the sixth loor could be rented and for what price, the company must decide
whether to split the Human Resources Department between currently unoccupied spaces
on several loors and rent out the entire sixth loor or to leave things as they currently are.
Which of the following should NOT be considered when deciding whether to rent out the
sixth loor?
A) the amount obtained by renting the sixth loor
B) the cost of refurbishing the new space to be occupied by the Human Resources
Department
C) cost involved with a loss of eiciency resulting from the Human Resources Department
being split between several spaces
D) the cost of the research into the feasibility of renting the sixth loor
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
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 university’s mascot.
C) A basketball manufacturer adds basketball hoops to its product line.
D) A convenience store begins selling pre-paid cell phones.
AACSB Objective: Analytic Skills
Author: WC
Question Status: Revised
32
8)
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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
33
9)
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 low
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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
10)
A bakery invests $40,000 in a light delivery truck. This was depreciated using the ive-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 low from the sale of this asset, given a tax
rate of 40%?
A) $11,520
B) $9480
C) $3792
D) $17,208
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
34
11)
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
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
35
12)
Year 0 Year 1 Year 2 Year 3
Revenues
500,000 500,000 500,000
– Cost of Goods Sold
-150,000 -150,000 -150,000
– Depreciation
-100,000 -100,000 -100,000
= EBIT
250,000
250,000 250,000
– Taxes (35%)
-87,500
-87,500 -87,500
= Unlevered net income
162,500
162,500 162,500
+ Depreciation 100,000 100,000 100,000
– Additions to Net Working
Capital -20,000 -20,000 -20,000
– Capital Expenditures
-300,000
= Free Cash Flow 242,500 242,500 242,500
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 low from this
project. The depreciation schedule shown is for three-year, straight-line depreciation. By
how much would the net present value (NPV) of this project be increased, if the cars were
depreciated by the MACRS schedule shown below given that the cost of capital is 10%?
A) $7266
B) $9082
C) $10,898
D) $22,705
– 1 2 3
Re $500,000 $500,000 $500,000
COGS
$(150,000
)
$(150,000
)
$(150,000
)
DEP $(99,990)
$(133,350
) $(44,430) $(22,230)
EBIT $(99,990)$ 216,650 $ 305,570 $327,770
Taxes $34,997$(75,828)
$(106,950
)
$(114,720
)
Unlev NI $(64,994)$ 140,822 $ 198,620 $ 213,050
DEP $99,990 $ 133.350 $ 44,430 $22,230
WC $ (20,000) $(20,000) $(20,000)
CAPEX
$(300,000
)
FCF
$(265,004
)$ 254,172 $ 223,050 $ 215,280
NPV $312,144
$312,144 – $303,062 = $9082
Dif: 1 Var: 35
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
13) Which of the following best explains why is it sensible for a irm to use an accelerated
depreciation schedule such as MACRS rather than straight-line depreciation?
A) The irm will substantially decrease its depreciation tax shield across all of the
depreciation timeline.
B) The irm can decide over how many years an item may be depreciated, thus allowing it
full control of its depreciation expenses.
C) The irm will have substantially fewer depreciation expenses later in the depreciation
timeline.
D) The irm will receive greater beneits to its cash low earlier in the depreciation timeline
and thus increase net present value (NPV).
AACSB Objective: Relective Thinking Skills
Author: DS
Question Status: Revised
37
14)
A machine is purchased for $575,000 and is used through the end of Year 2. The machine
will be depreciated using the 3-Year MACRS schedule. At the end of Year 2, the machine is
sold for $75,000. What is the after-tax cash low from the sale of the machine at the end of
Year 2 if the irm’s marginal tax rate is 35%?
A) $42,608
B) $15,916
C) $32,392
D) $63,663
AACSB Objective: Analytic Skills
Author: WC
Question Status: Revised
15)
A irm is considering the purchase of a new machine for $325,000. The irm is unsure if it
should use the 3-Year MACRS schedule or straight-line depreciation over three years. What
is the diference in the book value after three years if the irm uses MACRS instead of
straight-line depreciation?
A) $0
B) $24,083
C) $48,166
D) $300,918
AACSB Objective: Analytic Skills
Author: WC
Question Status: Revised
38
16) What are the most diicult parts of capital budgeting?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
17) What is the most important function of sensitivity analysis?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
18) What do you understand by break-even analysis?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
19) How are the taxes paid under MACRS diferent from that paid under straight-line
depreciation?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
20) If available, should MACRS be preferred to straight-line depreciation?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Revised
39
9.5 Analyzing the Project
1) The most diicult part of the capital budgeting process is accurately estimating cash
lows and cost of capital.
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
Use the igure for the question(s) below.
2) A consumer good company is developing a new brand of organic toothpaste. Above is the
sensitivity analysis for this product. The assumptions regarding which parameter should be
scrutinized most carefully in the estimation process?
A) units sold
B) sales price
C) cost of goods
D) cost of capital
AACSB Objective: Analytic Skills
Author: DS
Question Status: Revised
40