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Foundations of Finance, 9e (Keown/Martin/Petty)
Chapter 11 Cash Flows and Other Topics in Capital Budgeting
Learning Objective 11.1
1) Accounting profits are used to make capital budgeting decisions because generally accepted
accounting principles ensure that profits are the best measure of a company’s economic activity.
Keywords: Capital Budgeting Decisions, Accounting Profits vs Cash Flow
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
2) Capital budgeting decisions are based on free cash flow because free cash flow better reflects when
money is received and available for reinvestment than account profits.
Keywords: Capital Budgeting Decisions, Free Cash Flow, Accounting Profits
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
3) The guiding rule in deciding if a free cash flow is incremental is to look at the company with, versus
without, the new project.
Keywords: Incremental Free Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
4) A grocery store decides to offer beer for sale and this decision results in more potato chip sales. This is
an example of a synergistic effect.
Keywords: Synergistic Effects
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
5) Additional investment in working capital, even if it may be recovered at the end of a project, must be
included in capital budgeting analysis because of the time value of money.
Keywords: Additional Working Capital, Recovery of Additional Working Capital, Time Value of Money
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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6) Sunk costs are cash outflows that will occur regardless of the current accept/reject decision, and
therefore should be excluded from the analysis.
Keywords: Sunk Costs
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
7) Overhead costs are sometimes incremental cash flows and other times are considered sunk costs.
Keywords: Overhead Costs, Incremental Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
8) Interest payments on a loan obtained specifically to fund a new project should be considered an
incremental cash flow for the new project when determining the accept/reject decision.
Keywords: Financing Cash Flow, Incremental Cash Flow
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
9) To be included in a capital budgeting analysis, all incremental free cash flows must be expensed on the
company‘s books, otherwise generally accepted accounting principles will be violated.
Keywords: Incremental Free Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
10) In measuring cash flows, we are interested only in the incremental or incremental after-tax cash flows
that are attributed to the investment proposal being evaluated.
Keywords: Incremental After-Tax Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
11) The initial outlay for a new project is an example of an opportunity cost.
Keywords: Opportunity Cost
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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12) Synergistic benefits from an investment project include cannibalism.
Keywords: Synergistic Effects, Cannibalism
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
13) Toyota’s capital budgeting analysis for the Prius, a gas-electric hybrid, was faulty because the car line
has not made a profit to date.
Keywords: Capital Budgeting
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
14) Accounting profits, adjusted for taxes and differences in accounting methods, provide the best
measure of relevant cash flows for capital budgeting purposes.
Keywords: Accounting Profits, Cash Flow
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
15) Hershey‘s expects to sell $2 million of its new candy bar, although $200,000 of this amount would
have been spent on its existing candy bar. The $2 million is the appropriate cash inflow for the new candy
bar project, while the $200,000 will be counted against the return on the old candy bar.
Keywords: Incremental Cash Flows, Cannibalism
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
16) Adding gourmet coffee stations to my convenience store is expected to increase sales of my breakfast
sandwiches; however, the sales of breakfast sandwiches should not be included in the evaluation of the
gourmet coffee project because only relevant, incremental cash flows should be considered.
Keywords: Synergistic Effects
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
17) As a rule, any cash flows that are not affected by the accept/reject criterion should not be included in
capital-budgeting analysis.
Keywords: Sunk Costs
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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18) If a project uses an asset the corporation already owns, the cost of that asset for capital budgeting
purposes is zero to reflect the advantage the project has over projects that require the purchase of new
assets.
Keywords: Opportunity Cost
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
19) For companies in competitive markets, the evolution and introduction of new products may serve
more to preserve market share than to expand it.
Keywords: Capital Budgeting, Synergistic Effects
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
20) TRL, Inc. has spent $2,000,000 in nonrefundable engineering fees in contemplation of building a
convention center and the additional costs to complete the project are $18,000,000. The present value of all
benefits the center will produce in its lifetime are $19,000,000, so TRL should not build the convention
center.
Keywords: Sunk Costs
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
21) An opportunity cost is a relevant incremental cost for capital budgeting decisions.
Keywords: Opportunity Costs, Incremental Costs
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
22) The calculation of incremental free cash flows over a project’s life should include
A) labor and material saving.
B) additional revenue.
C) interest to bondholders.
D) A and B.
Keywords: Incremental Free Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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23) Tillamook Farms invests in a new kind of frozen dessert called polar cream that becomes very
popular. So many new customers come to the store that the sales of existing ice cream products are
increased. The extra sales revenue
A) should not be counted as incremental revenue for the polar cream project because the sales come from
existing products.
B) are synergistic effects that should be counted as incremental revenues for the polar cream project.
C) are cannibalized sales that should be excluded from the analysis.
D) should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring
expense.
Keywords: Synergistic Effects, Incremental Revenues
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
24) Sunk costs are
A) recoverable.
B) incremental.
C) not relevant in capital budgeting.
D) not deductible for tax purposes.
Keywords: Sunk Costs
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
25) Solar Confectionary develops a new candy bar and plans to sell each bar for $1. Solar predicts that 1
million candy bars will be sold in the first year if the new candy bar is produced and sold, and includes
$1 million of incremental revenues in its capital budgeting analysis. A senior executive in the company
believes that 1 million candy bars will be sold, but lowers the estimate of incremental revenue to $700,000.
What would explain this change?
A) cannibalization of 300,000 of Solar Confectionary’s other candy bars
B) excessive marketing costs to sell the 1 million candy bars
C) a lower discount rate
D) a higher selling price for the new candy bars
Keywords: Incremental Revenues, Cannibalization
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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26) Redrock Inc. is a household products firm that is considering developing a new detergent. In
evaluating whether to go ahead with the new detergent project, which of the following statements is
MOST correct?
A) The company will produce the detergent in a building that they already own. The cost of the building
is therefore zero and should be excluded from the analysis.
B) The company will need to use some equipment that it could have leased to another company. This
equipment lease could have generated $200,000 per year in after-tax income. The $200,000 should be
excluded because the equipment can no longer be leased.
C) The company will need to hire 10 new workers whose salaries and benefits will total $400,000 per year.
Labor costs are not part of capital budgeting and should be excluded.
D) The company will produce the detergent in a building that it renovated 2 years ago for $300,000. The
$300,000 should be excluded from the analysis.
Keywords: Opportunity Costs, Sunk Costs, Incremental Expenses
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
27) AFB Systems is considering a new marketing campaign that will require the addition of a new
computer programmer and new software. The programmer will occupy an office in AFB‘s current
building and will be paid $8,000 per month. The software license costs $1,000 per month. The rent for the
building is $4,000 per month. AFB’s computer system is always on, so running the new software will not
change the current monthly electric bill of $900. The incremental expenses for the new marketing
campaign are
A) $13,900 per month.
B) $9,000 per month.
C) $13,000 per month.
D) $8,000 per month.
Keywords: Overhead Costs, Incremental Expenses
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
28) A local restaurant owner is considering expanding into another rural area. The expansion project will
be financed through a line of credit with City Bank. The administrative costs of obtaining the line of credit
are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy
an existing building that can be rented for $2,500 per month. The incremental cash flows for the new
restaurant include
A) $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent.
B) $500 administrative costs, $2,500 per month rent.
C) $1,000 per month interest payments, $2,500 per month rent.
D) $2,500 per month rent.
Keywords: Financing Cash Flow, Incremental Cash Flow
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
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29) Butler Automotive developed a new diagnostic testing procedure that is expected to increase sales by
$10,000 per month. As more drivers bring in their vehicles, Butler expects to also do more oil changes and
brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues
from oil changes and brake jobs are expected to increase by $4,000 per month. An example of a
synergistic effect from the new diagnostic testing procedure is the
A) increase in inventory levels of oil and brake parts.
B) increase in revenue of $10,000 per month for the diagnostic testing.
C) increase in revenues from oil changes and brake jobs of $4,000 per month.
D) increase in all activities totaling $19,000 per month.
Keywords: Synergistic Effects
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
30) Butler Automotive developed a new diagnostic testing procedure that is expected to increase sales by
$10,000 per month. As more drivers bring in their vehicles, Butler expects to also do more oil changes and
brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues
from oil changes and brake jobs are expected to increase by $4,000 per month. An example of an increase
in net working capital requirements from the new diagnostic testing procedure is the
A) increase in inventory levels of oil and brake parts of $5,000.
B) increase in revenue of $10,000 per month for the diagnostic testing.
C) increase in revenues from oil changes and brake jobs of $4,000 per month.
D) increase in all activities totaling $19,000 per month.
Keywords: Net Working Capital
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
31) Incremental cash flows refer to
A) the difference between after-tax cash flows and before-tax accounting profits.
B) the new cash flows that will be generated if a project is undertaken.
C) the cash flows of a project, minus financing costs.
D) the cash flows that are foregone if a firm does not undertake a project.
Keywords: Incremental Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
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32) Which of the following should be included in an analysis of a new project‘s cash flows?
A) any sales from existing products that would be lost if customers were expected to purchase a new
product instead
B) all financing costs
C) all sunk costs
D) no opportunity costs
Keywords: Cannibalization, Financing Cash Flows, Sunk Costs, Opportunity Costs
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
33) It is important to consider a new project’s affect on the cash flows of existing projects because of
A) cannibalism.
B) synergy.
C) sunk costs.
D) A and B above.
Keywords: Cannibalism, Synergy
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
34) Which of the following expenses associated with a project should NOT be included in a capital
budgeting analysis?
A) additional allocated fixed overhead from corporate headquarters
B) additional maintenance expenses associated with new equipment
C) reengineering of a production line associated with a new project
D) training sales staff on a new product
Keywords: Incremental Cash Flows, Overhead, Initial Outlay
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
35) A company is expanding and has already signed a lease on new office space that costs $10,000 per
month. The company also needs a new information system and hired a consultant to recommend new
software. The consultant was paid $5,000 for her recommendation. Now the company is trying to make a
choice between three competing software products. In the capital budgeting decision to purchase new
software, the monthly rent for the office space is ________ and the consultant’s fee is ________.
A) a sunk cost; a sunk cost
B) an opportunity cost; a sunk cost
C) incremental cash outflow; an opportunity cost
D) a sunk cost; a part of the initial outlay
Keywords: Sunk Costs
Learning Obj.: L.O. 11.1
AACSB: Analytical Thinking
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36) As part of its expansion project, A.J. Industries Equipment Division has expanded its office space by
200 square feet. The company‘s administrative overhead is allocated based on the square footage of each
business segment. Although the total administrative overhead for the company will remain the same, the
Equipment Division will be charged more for administrative overhead. For the Equipment Division
expansion project, the administrative overhead is an example of a(n)
A) incremental cash flow.
B) sunk cost.
C) opportunity cost.
D) incremental opportunity cash flow.
Keywords: Sunk Costs, Overhead, Incremental Cash Flow
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
37) What is an incremental cash flow? What is a sunk cost? Why must you account for opportunity costs?
Keywords: Incremental Cash Flows
Learning Obj.: L.O. 11.1
AACSB: Reflective Thinking
Learning Objective 11.2
1) In general, a project’s free cash flows will fall in one of the following three categories: initial outlay,
differential cash flows over the project’s life, and the terminal cash flow.
Keywords: Free Cash Flow, Initial Outlay, Differential Cash Flows, Terminal Cash Flow
Learning Obj.: L.O. 11.2
AACSB: Reflective Thinking
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2) If an old asset is sold for less than its book value, the resulting loss will save the company taxes, hence
lowering the cost of the project.
Keywords: Tax Effect, Sale of Old Machine, Book Value
Learning Obj.: L.O. 11.2
AACSB: Analytical Thinking
3) If an old asset is sold for its depreciated, or book, value, then no taxes result and there is no tax effect
from the sale.
Keywords: Tax Effect, Sale of Old Asset, Book Value
Learning Obj.: L.O. 11.2
AACSB: Analytical Thinking
4) One example of a terminal cash flow is the recapture of the net working capital associated with the
project.
Keywords: Terminal Cash Flow, Recapture, Net Working Capital
Learning Obj.: L.O. 11.2
AACSB: Reflective Thinking
5) The initial outlay of a project may be reduced by the after-tax salvage value of replaced equipment.
Keywords: Initial Outlay, Salvage Value
Learning Obj.: L.O. 11.2
AACSB: Reflective Thinking
6) A weakness in the capital budgeting process is the funds for an investment proposal obtained by
issuing bonds, and the respective interest payments, are not considered in the capital budgeting process.
Keywords: Interest Payments, Capital Budgeting Process
Learning Obj.: L.O. 11.2
AACSB: Reflective Thinking
7) The initial outlay includes the immediate cash outflow necessary to purchase the asset and put it in
operating order.
Keywords: Initial Outlay
Learning Obj.: L.O. 11.2
AACSB: Reflective Thinking