Principles of Managerial Finance, Brief Ed., 8e (Zutter/Smart)
Chapter 11 Capital Budgeting Cash Flows and Risk Refinements
11.1 Project cash flows
1) Accounting figures and cash flows are not necessarily the same due to the presence of certain
non-cash expenditures on a firm’s income statement.
2) Relevant cash flows are the incremental cash outflows and inflows associated with a proposed
capital expenditure.
3) The relevant cash flows for a proposed capital expenditure are the incremental after-tax cash
outflows and resulting subsequent inflows.
4) Please explain the difference between a sunk cost and an opportunity cost and give an
example of each type of cost.
5) Incremental cash flows represent the additional cash flows expected as a direct result of the
proposed project.
6) The three major cash flow components include the initial investment, operating cash flows,
and terminal cash flow.
7) The three major cash flow components include the initial investment, nonoperating cash
flows, and terminal cash flow.
8) Initial cash outflows and subsequent operating cash inflows for a project are referred to as
________.
A) necessary cash flows
B) relevant cash flows
C) perpetual cash flows
D) ordinary cash flows
9) Relevant cash flows for a project are best described as ________.
A) incidental cash flows
B) incremental cash flows
C) sunk cash flows
D) contingent cash flows
10) Should financing costs such as the returns paid to bondholders and stockholders be
considered in computing after-tax operating cash flows? Why or why not?
11) Sunk costs are cash outlays that have already been made and therefore have no effect on the
cash flows relevant to the current decision.
12) Opportunity costs should be included as cash outflows when determining a project’s
incremental cash flows.
13) A sunk cost is a cash flow that could be realized from the best alternative use of an owned
asset.
14) An opportunity cost is a cash flow that could be realized from the best alternative use of an
owned asset.
15) A sunk cost is a cash outlay that has already been made and cannot be recovered.
16) Companies involved in international capital budgeting projects can minimize the long-term
currency risk by financing the foreign investment at least partly in the local capital markets.
17) Companies involved in international capital budgeting projects can minimize political risks
by structuring the investment as a joint venture and selecting a well-connected local partner.
18) When making replacement decisions, the development of relevant cash flows is complicated
when compared to expansion decisions, due to the need to calculate ________ cash inflows.
A) conventional
B) opportunity
C) incremental
D) sunk
19) In developing the cash flows for an expansion project, the analysis is the same as the analysis
for replacement projects where ________.
A) all cash flows from the old assets are equal
B) prior cash flows are irrelevant
C) all cash flows from the old asset are zero
D) cash inflows equal cash outflows
20) Cash outlays that had been previously made and have no effect on the cash flows relevant to
a current decision are called ________.
A) incremental historical costs
B) incremental past expenses
C) opportunity costs foregone
D) sunk costs
21) Cash flows that could be realized from the best alternative use of an owned asset are called
________.
A) incremental costs
B) lost resale opportunities
C) opportunity costs
D) sunk costs
1) If a new asset is being considered as a replacement for an old asset, the relevant cash flows
would be found by adding the operating cash flows from the old asset to the operating cash flows
from the new asset.
2) Calculate the book value of the existing press being replaced. (See Table 11.1)
3) Calculate the tax effect from the sale of the existing asset. (See Table 11.1)
4) Calculate the initial investment of the new asset. (See Table 11.1)
5) To calculate the initial investment, we subtract all cash inflows occurring at time zero from all
cash outflows occurring at time zero.
6) The basic cash flows that must be considered when determining the initial investment
associated with a capital expenditure are the installed cost of the new asset, the after-tax proceeds
(if any) from the sale of an old asset, and the change (if any) in net working capital.
7) Under MACRS depreciation, the depreciable value of an asset is equal to the asset’s purchase
price minus any installation costs.
8) The change in net working capital—regardless of whether an increase or decrease—is not
taxable because it merely involves a net buildup or net reduction of current accounts.
9) If an investment in a new asset results in a change in current assets that exceeds the change in
current liabilities, this change in net working capital represents an initial cash outflow.
10) Net working capital is the difference between a firm’s total assets and its total liabilities.
11) Which of the following would be used in the computation of an initial investment?
A) the annual after-tax inflow expected from the investment
B) the initial purchase price of the investment
C) the historic cost of the existing investment
D) the profits from the new investment
12) Which of the following basic variables must be considered in determining the initial
investment associated with a capital expenditure?
A) incremental annual savings produced by the new asset
B) cash flows generated by the new investment
C) proceeds from the sale of an existing asset
D) profits on the sale of an existing asset
13) An important cash inflow in the analysis of initial cash flows for a replacement project is
________.
A) taxes
B) the cost of the new asset
C) installation cost
D) the sale value of the old asset
14) When evaluating a capital budgeting project, installation costs of a new machine must be
considered as part of ________.
A) the operating cash inflows
B) the initial investment
C) the incremental operating cash inflows
D) the operating cash outflows
15) The change in net working capital when evaluating a capital budgeting decision is ________.
A) the change in fixed liabilities minus the change in fixed assets
B) the increase in current assets
C) the increase in current liabilities
D) the change in current assets minus the change in current liabilities
16) In evaluating the initial investment for a capital budgeting project, ________.
A) an increase in net working capital is considered a cash inflow
B) a decrease in net working capital is considered a cash outflow
C) an increase in net working capital is considered a cash outflow
D) net working capital does not have to be considered
17) A corporation is considering expanding operations to meet growing demand. With the capital
expansion, the current accounts are expected to change. Management expects cash to increase by
$20,000, accounts receivable by $40,000, and inventories by $60,000. At the same time accounts
payable will increase by $50,000, accruals by $10,000, and long-term debt by $100,000. The
change in net working capital is ________.
A) an increase of $120,000
B) a decrease of $60,000
C) a decrease of $120,000
D) an increase of $60,000
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18) A corporation is considering expanding operations to meet growing demand. With the capital
expansion the current accounts are expected to change. Management expects cash to increase by
$10,000, accounts receivable by $20,000, and inventories by $30,000. At the same time accounts
payable will increase by $40,000, accruals by $30,000, and long-term debt by $80,000. The
change in net working capital is ________.
A) an increase of $10,000
B) a decrease of $10,000
C) a decrease of $90,000
D) an increase of $80,000
19) If accounts receivable increase by $1,000,000, inventory decreases by $500,000, and
accounts payable increase by $500,000, net working capital would ________.
A) decrease by $500,000
B) increase by $1,500,000
C) increase by $2,000,000
D) experience no change
MACRS RATE
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
15
19
18
14
4
7
12
12
12
5
12
9
9
6
5
9
8
7
9
7
8
4
6
9
6
10
6
11
4
20) A corporation has decided to replace an existing asset with a newer model. Two years ago,
the existing asset originally cost $30,000 and was being depreciated under MACRS using a five-
year recovery period. The existing asset can be sold for $25,000. The new asset will cost $75,000
and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax
rate is 40 percent on ordinary income and capital gains, the initial investment is ________.
A) $42,000
B) $52,440
C) $54,240
D) $50,000
21) A corporation has decided to replace an existing asset with a newer model. Two years ago,
the existing asset originally cost $70,000 and was being depreciated under MACRS using a five-
year recovery period. The existing asset can be sold for $30,000. The new asset will cost $80,000
and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax
rate is 40 percent on ordinary income and capital gains, the initial investment is ________.
A) $48,560
B) $44,360
C) $49,240
D) $27,600
11.3 Finding the operating cash flows
1) Suppose the tax law changes to allow firms to immediately and fully deduct the cost of
investments they make rather than depreciating them under the MACRS system. If all else
remains the same, this change would tend to increase the NPV of an investment project.
2) All other factors held constant, the higher the tax rate that firms must pay, the more valuable
are depreciation deductions.
3) All other factors held constant, the longer the firm must take to depreciate the initial cost of an
investment project, the higher will be the project’s NPV.
4) In terms of an investment project’s operating cash flows, depreciation deductions are irrelevant
because they do not represent an outlay of cash.
5) This year a certain investment project generated revenue of $200,000. Other expenses
(excluding depreciation and interest expense) totalled $100,000. Depreciation expense was
$50,000 and interest expense was $10,000. The firm faces a tax rate of 21%. What is the project’s
after-tax operating cash flow this year?
A) $89,500
B) $81,600
C) $129,000
D) $79,000
6) John has an extra bedroom in his house that he occasionally rents out using the service
Airbnb. John charges $100 per night, and his room is occupied by a renter approximately 100
nights per year. He thinks that if he repaints the room the photos he posts on Airbnb to draw
customers will be more attractive, allowing him to charge $110 dollars per night and to rent the
room for 120 nights per year. John’s tax rate is 28%. What is the annual, after-tax, incremental
revenue that John expects from his painting project?
A) $13,200
B) $9,504
C) $3,200
D) $2,304
1) The book value of an asset is equal to its installed cost of asset minus the accumulated
depreciation.
2) In case of an existing asset which is depreciable and is used in business and is sold for a price
equal to its initial purchase price, the difference between the sales price and its book value is
considered as recaptured depreciation and will be taxed as ordinary income.
3) Recaptured depreciation is the portion of the sale price that is below the book value.
4) Capital gain is the portion of the sale price that is in excess of the initial purchase price.
5) Recaptured depreciation is the portion of the sale price that is in excess of the initial purchase
price.
6) If an asset is depreciable and used in business, any loss on the sale of the asset is tax-
deductible only against other capital gains income, not against ordinary income.
7) If an asset is sold for more than its initial purchase price, the gain on the sale is composed of
two parts: a capital gain and recaptured depreciation.
8) If an asset is sold for book value, the gain on the sale is composed of two parts: a capital gain
and accumulated depreciation.
9) If an asset is sold for less than its book value, the loss on the sale may be used to offset
ordinary operating income provided the asset is used in the business.
10) The book value of an asset is equal to the ________.
A) fair market value minus the accounting value
B) original purchase price plus annual depreciation expense
C) original purchase price minus accumulated depreciation
D) depreciated value plus recaptured depreciation
11) The tax treatment regarding the sale of existing assets that are sold for more than the original
purchase price results in ________.
A) an ordinary tax benefit
B) no tax benefit or liability
C) a recaptured depreciation taxed as ordinary income
D) a capital gain tax liability
12) The tax treatment regarding the sale of existing assets that are sold for more than the book
value but less than the original purchase price results in a(n) ________.
A) ordinary tax benefit
B) capital gain tax liability
C) recaptured depreciation taxed as ordinary income
D) capital gain tax liability and recaptured depreciation taxed as ordinary income
13) The tax treatment regarding the sale of existing assets that are sold for their book value
results in ________.
A) an ordinary tax benefit
B) no tax benefit or liability
C) recaptured depreciation taxed as ordinary income
D) a capital gain tax liability and recaptured depreciation taxed as ordinary income
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14) The portion of an asset’s sale price that is above its book value and below its initial purchase
price is called ________.
A) a capital gain
B) recaptured depreciation
C) a capital loss
D) book value
15) The portion of an asset’s sale price that is below its book value and below its initial purchase
price is called ________.
A) a capital gain
B) recaptured depreciation
C) a capital loss
D) book value
16) The tax treatment regarding the sale of existing assets that are sold for less than the book
value results in ________.
A) an ordinary tax benefit
B) a capital loss tax benefit
C) recaptured depreciation taxed as ordinary income
D) a capital gain tax liability and recaptured depreciation taxed as ordinary income
MACRS RATE
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
15
19
18
14
4
7
12
12
12
5
12
9
9
6
5
9
8
7
9
7
8
4
6
9
6
10
6
11
4
17) A corporation is selling an existing asset for $21,000. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $7,560 tax liability
C) $4,400 tax liability
D) $7,720 tax liability
18) A corporation is selling an existing asset for $1,700. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $840 tax liability
C) $3,160 tax liability
D) $3,160 tax benefit
19) A corporation is selling an existing asset for $1,000. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $1,100 tax liability
C) $3,600 tax liability
D) $280 tax benefit
20) A firm is selling an existing asset for $5,000. The asset, when purchased, cost $10,000, was
being depreciated under MACRS using a five-year recovery period and has been depreciated for
four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax
effect of this transaction is ________.
A) $0 tax liability
B) $1,320 tax liability
C) $1,160 tax liability
D) $2,000 tax benefit
21) A loss on the sale of an asset that is depreciable and used in business is ________; a loss on
the sale of a non-depreciable asset is ________.
A) deductible from capital gains income; deductible from ordinary income
B) deductible from ordinary income; deductible only against capital gains
C) a credit against the tax liability; not deductible
D) not deductible; deductible only against capital gains