978-0134083285 Chapter 11 Part 2

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8) If the increase in net working capital is recovered entirely at the end of the project, then it may be

ignored.

Keywords: Net Working Capital, Recovery of Net Working Capital

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

9) Cash flows associated with a project’s termination generally include the salvage value of the project net

of any taxes associated with the sale.

Keywords: Terminal Year Cash Flows, Salvage Value, Tax Effect

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

10) Increasing depreciation expense results in a decrease of the incremental after-tax free cash flow.

Keywords: Depreciation, Incremental Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

11) Increases in working capital needs should be included as part of the initial outlay of a project, but

decreases in working capital for a project should not be considered because they are not guaranteed.

Keywords: Working Capital Requirements, Initial Outlay

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

12) Any increase in interest payments caused by a project should be counted in the incremental cash

flows.

Keywords: Interest Payments, Financing Cash Flows, Incremental Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

13) Terminal cash flows are always positive because they result from the shutting down of a project with

the sale of any assets with remaining value.

Keywords: Terminal Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

14) Proceeds from the issuance of new debt and principal payments upon maturity of debt used to

finance a project should be included in the calculation of the project’s after-tax cash flows.

Keywords: Financing Cash Flow, Incremental After-tax Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

15) Interest payments on debt are not included in a project’s incremental cash flows, but are instead

accounted for in the project’s discount rate.

Keywords: Interest Payments, Financing Cash flows, Incremental Cash Flows, Discount Rate

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

16) Depreciation is a non-cash deduction so it may be ignored in the calculation of a project’s incremental

after-tax cash flows.

Keywords: Depreciation, Non-cash Expense, Incremental After-tax Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

17) Depreciation expense produces a cash inflow equal to the depreciation expense multiplied by the

firm’s marginal tax rate.

Keywords: Depreciation Expense, Cash Inflow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

18) Free cash flow calculations can be broken down into three parts: cash flows from operations, cash

flows associated with working-capital requirements, and financing cash flows relating to interest and

dividend payments.

Keywords: Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

19) Capital budgeting projects that expand sales are more likely to involve increases in working capital

than are projects that involve the replacement of existing assets.

Keywords: Working-Capital Requirements

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

20) Increases in inventory and accounts receivable expected to occur if a proposed advertising campaign

is undertaken are examples of sunk costs.

Keywords: Working-Capital Requirements, Sunk Costs

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

21) In general, a project’s free cash flows will fall into one of three categories: (1) incremental costs, (2)

sunk costs, and (3) opportunity costs.

Keywords: Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

22) The initial outlay includes the cost of purchasing the asset and getting it operational, including the

purchase price, shipping and installation, and any training costs for employees who will be operating the

equipment, and any increases in working capital requirements.

Keywords: Initial Outlay

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

23) The initial outlay includes the cost of purchasing the asset and getting is operational, but this excludes

any training costs for employees which should be included as part of differential cash flows over the life

of the project.

Keywords: Initial Outlay

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

24) In a replacement decision, the initial outlay is equal to the cost of the new asset less the reduction in

depreciation from elimination of the old asset.

Keywords: Replacement Project, Initial Outlay

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

25) Operating cash flow is equal to the change in EBIT less the change in interest expense, less the change

in taxes, plus the change in depreciation.

Keywords: Operating Cash Flow, Interest Expense

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

26) Changes in capital spending are not incorporated directly into capital budgeting problems because

the amounts are included in the operating cash flows through the inclusion of depreciation expense.

Keywords: Capital Spending, Free Cash Flows, Operating Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

27) A project‘s annual free cash flow is the change in operating cash flow less any change in net working

capital and less any change in capital spending.

Keywords: Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

28) A project‘s annual free cash flow is the change in operating cash flow less any change in net working

capital and less any change in capital spending.

Keywords: Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

29) Interest expenses are not included as incremental free cash flows because the cost of funds is

recognized when cash flows are discounted back to present value.

Keywords: Interest Expense, Risk-Adjusted Discount Rate

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

30) Blackjack Inc. wants to replace a 9-year-old machine with a new machine that is more efficient. The

old machine cost $70,000 when new and has a current book value of $15,000. Blackjack can sell the

machine to a foreign buyer for $14,000. Blackjack’s tax rate is 35%. The effect of the sale of the old machine

on the initial outlay for the new machine is

A) ($14,350).

B) ($13,650).

C) ($9,100).

D) $1,000.

Keywords: Tax Effect, Sale of Old Machine, Book Value

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

31) You are analyzing the purchase of new equipment. Since you are not an expert on this type of

equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and

recommended the purchase of the latest model from ACME Corp. of America. The equipment costs

$80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be

depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will

be sold after three years for $28,000. Use of the equipment will require an increase in your company‘s net

working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the

equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-

tax operating costs. Your company‘s marginal tax rate is 35%. What is the initial outlay required to fund

this project?

A) $80,000

B) $84,000

C) $90,000

D) $94,000

Keywords: Initial Outlay, Sunk Costs

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

32) You are analyzing the purchase of new equipment. Since you are not an expert on this type of

equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and

recommended the purchase of the latest model from ACME Corp. of America. The equipment costs

$80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be

depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will

be sold after three years for $28,000. Use of the equipment will require an increase in your company‘s net

working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the

equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before–

tax operating costs. Your company‘s marginal tax rate is 35%. What is the incremental free cash flow for

the first year of the project?

A) $23,800

B) $29,850

C) $32,440

D) $37,750

Keywords: Incremental Free Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

33) You are analyzing the purchase of new equipment. Since you are not an expert on this type of

equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and

recommended the purchase of the latest model from ACME Corp. of America. The equipment costs

$80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be

depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will

be sold after three years for $28,000. Use of the equipment will require an increase in your company‘s net

working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the

equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before–

tax operating costs. Your company‘s marginal tax rate is 35%. What is the terminal cash flow for this

project?

A) ($17,000)

B) $24,500

C) $33,950

D) $37,950

Keywords: Terminal Cash Flow, Recapture of Net Working Capital, Tax Effect

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

34) A new project is expected to generate $800,000 in revenues, $250,000 in cash operating expenses, and

depreciation expense of $150,000 in each year of its 10-year life. The corporation‘s tax rate is 35%. The

project will require an increase in net working capital of $85,000 in year one and a decrease in net

working capital of $75,000 in year ten. What is the free cash flow from the project in year one?

A) $298,000

B) $375,000

C) $380,000

D) $410,000

Keywords: Free Cash Flow, EBIT, Depreciation Expense, Net Working Capital

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

35) Smith Manufacturing Inc. expects the following results in year one of a new project:

Revenue

$400,000

Cash Expenses

150,000

Depreciation

90,000

EBIT

$160,000

Taxes

48,000

Net Income

$112,000

The annual change in operating cash flow is equal to

A) $298,000.

B) $202,000.

C) $160,000.

D) $250,000.

Keywords: Operating Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

36) Your company is considering the replacement of an old delivery van with a new one that is more

efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated

using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for

$7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the

company‘s products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years,

at which time the van will be sold for its estimated salvage value of $18,000. The new van will be

depreciated using the simplified straight-line method over its 5-year useful life. The company‘s tax rate is

35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will

be recaptured at the end of year five. What is the incremental free cash flow for year one?

A) $18,875

B) $19,985

C) $22,305

D) $24,220

Keywords: Incremental Free Cash Flows, Depreciation

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

37) Your company is considering the replacement of an old delivery van with a new one that is more

efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated

using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for

$7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the

company‘s products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years,

at which time the van will be sold for its estimated salvage value of $18,000. The new van will be

depreciated using the simplified straight-line method over its 5-year useful life. The company‘s tax rate is

35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will

be recaptured at the end of year five. What is the terminal cash flow?

A) $23,000

B) $18,000

C) $17,250

D) $16,700

Keywords: Terminal Cash Flow, Salvage Value, Tax Effect, Recapture of Net Working Capital

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

38) The recapture of net working capital at the end of a project will

A) increase terminal year free cash flow.

B) decrease terminal year free cash flow by the change in net working capital times the corporate tax rate.

C) increase terminal year free cash flow by the change in net working capital times the corporate tax rate.

D) have no effect on the terminal year free cash flow because the net working capital change has already

been included in a prior year.

Keywords: Recapture of Net Working Capital, Terminal Year Free Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

39) If depreciation expense in year one of a project increases for a highly profitable company,

A) net income decreases and incremental free cash flow decreases.

B) net income increases and incremental free cash flow increases.

C) the book value of the depreciating asset increases at the end of year one.

D) net income decreases and incremental free cash flow increases.

Keywords: Depreciation Expense, Incremental Free Cash Flow, Taxes

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

40) Salvage value would most likely NOT be considered by

A) net present value.

B) internal rate of return.

C) payback.

D) A and B.

Keywords: Salvage Value, Payback Period

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

41) Which of the following cash flows are NOT considered in the calculation of the initial outlay for a

capital investment proposal?

A) increase in accounts receivable

B) cost of issuing new bonds if the project is financed by a new bond issue

C) installation costs

D) None of the above—all are considered.

Keywords: Initial Outlay, Financing Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

42) Which of the following is NOT considered in the calculation of incremental cash flows?

A) tax saving due to increased depreciation expense

B) interest payments if new debt is issued

C) increased dividend payments if additional preferred stock is issued

D) B and C

Keywords: Incremental Cash Flows, Financing Cash Flows

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

43) XYZ, Inc. has developed a project which results in additional accounts receivable of $400,000,

additional inventory of $180,000, and additional accounts payable of $70,000. What is the additional

investment in net working capital?

A) $580,000

B) $510,000

C) $270,000

D) $150,000

Keywords: Net Working Capital

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

44) AFB, Inc. requires an investment in equipment of $600,000 to replace existing equipment. The existing

equipment will produce after-tax salvage value of $70,000. Net working capital requirements are

increased by $50,000. What is the total cash outflow at time zero?

A) $720,000

B) $650,000

C) $530,000

D) $580,000

Keywords: Initial Outlay, Net Working Capital

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

45) A six-year project for Little Egypt, Inc. results in additional accounts receivable of $150,000, additional

inventory of $50,000, and additional accounts payable of $80,000 today. What is the change in the NPV of

a project solely due to the additional net working capital (NWC) needs? Assume a 14% discount rate, and

the recovery of net working capital at the end of the project.

A) a decrease of $34,606

B) a decrease of $42,670

C) a decrease of $120,000

D) a decrease of $58,689

Keywords: Additional Net Working Capital, NPV

Learning Obj.: L.O. 11.2

AACSB: Analytical Thinking

46) Which of the following should be included in the initial outlay?

A) taxable gain on the sale of old equipment being replaced

B) first year depreciation expense on any new equipment purchased

C) preexisting firm overhead reallocated to the new project

D) increased investment in inventory and accounts receivable

Keywords: Initial Outlay

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking

47) Increased depreciation expenses affect tax-related cash flows by

A) increasing taxable income, thus increasing taxes.

B) decreasing taxable income, thus reducing taxes.

C) decreasing taxable income, with no effect on cash flow since depreciation is a non-cash expense.

D) pushing a corporation into a higher tax bracket.

Keywords: Depreciation Expense, Tax-Related Cash Flow

Learning Obj.: L.O. 11.2

AACSB: Reflective Thinking