22) Compute the initial purchase price for an asset with book value of $34,800 and total
accumulated depreciation of $85,200.
24) An asset was purchased three years ago for $100,000 and can be sold for $40,000 today. The
asset has been depreciated using the MACRS 5-year recovery period and the firm pays 40
percent taxes on both ordinary income and capital gain.
(a) Compute recaptured depreciation and capital gain (loss), if any.
(b) Find the firm’s tax liability.
25) A machine was purchased two years ago for $120,000 and can be sold for $50,000 today.
The machine has been depreciated using the MACRS 5-year recovery period and the firm pays
40 percent taxes on both ordinary income and capital gains.
(a) Compute recaptured depreciation and capital gain (loss), if any.
(b) Find the firm’s tax liability.
26) Compute the depreciation values for an asset which costs $55,000 and requires $5,000 in
installation costs using MACRS 5-year recovery period.
27) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must
estimate the terminal cash flow. The proposed machine will be disposed of at the end of its
usable life of five years at an estimated sale price of $15,000. The machine has an original
purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-
year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent
tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________.
A) $24,000
B) $16,000
C) $14,000
D) $26,000
28) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must
estimate the terminal cash flow. The proposed machine will be disposed of at the end of its
usable life of five years at an estimated sale price of $2,000. The machine has an original
purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-
year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent
tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________.
A) $5,800
B) $7,800
C) $8,200
D) $6,200
29) Which of the following must be considered in computing the terminal value of a replacement
project?
A) operating cash flow for the final year
B) after-tax proceeds from the sale of a new asset
C) before-tax proceeds from the sale of an old asset
D) before-tax proceeds from the sale of a new asset
11.5 Risk in capital budgeting (behavioral approaches)
Table 11.3
Cuda Marine Engines, Inc. must develop the relevant cash flows for a replacement capital
investment proposal. The proposed asset costs $50,000 and has installation costs of $3,000. The
asset will be depreciated using a five-year recovery schedule. The existing equipment, which
originally cost $25,000 and will be sold for $10,000, has been depreciated using an MACRS
five-year recovery schedule and three years of depreciation has already been taken. The new
equipment is expected to result in incremental before-tax net profits of $15,000 per year. The
firm has a 40 percent tax rate.
1) The cash flow pattern for the capital investment proposal is ________. (See Table 11.3)
A) a mixed stream and conventional
B) a mixed stream and nonconventional
C) a perpetuity and conventional
D) an annuity and nonconventional
2) The book value of the existing asset is ________. (See Table 11.3)
A) $7,250
B) $15,000
C) $21,250
D) $25,000
3) The tax effect on the sale of the existing asset results in ________. (See Table 11.3)
A) $800 tax benefit
B) $1,000 tax liability
C) $1,100 tax liability
D) $6,000 tax liability
4) The initial outlay equals ________. (See Table 11.3)
A) $41,100
B) $44,100
C) $38,800
D) $38,960
5) The incremental depreciation expense for year 1 is ________. (See Table 11.3)
A) $2,250
B) $7,600
C) $7,000
D) $7,950
6) The incremental depreciation expense for year 5 is ________. (See Table 11.3)
A) $2,250
B) $5,110
C) $7,950
D) $6,360
7) The annual incremental after-tax cash flow from operations for year 1 is ________. (See Table
11.3)
A) $13,950
B) $16,600
C) $25,600
D) $30,000
Table 11.4
Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering
replacing an existing piece of equipment with a more sophisticated machine. The following
information is given.
The firm pays 40 percent taxes on ordinary income and capital gains.
8) Calculate the book value of the existing asset being replaced. (See Table 11.4)
9) Calculate the tax effect from the sale of the existing asset. (See Table 11.4)
10) Calculate the initial investment required for the new asset. (See Table 11.4)
11) Calculate the incremental earnings before depreciation and taxes. (See Table 11.4)
12) Calculate the incremental depreciation. (See Table 11.4)
13) Summarize the incremental after-tax cash flow (relevant cash flows) for years t = 0 through t
= 5. (See Table 11.4)
Table 11.5
Nuff Folding Box Company, Inc. is considering purchasing a new gluing machine. The gluing
machine costs $50,000 and requires installation costs of $2,500. This outlay would be partially
offset by the sale of an existing gluer. The existing gluer originally cost $10,000 and is four years
old. It is being depreciated under MACRS using a five-year recovery schedule and can currently
be sold for $15,000. The existing gluer has a remaining useful life of five years. If held until year
5, the existing machine’s market value would be zero. Over its five-year life, the new machine
should reduce operating costs (excluding depreciation) by $17,000 per year. Training costs of
employees who will operate the new machine will be a one-time cost of $5,000 which should be
included in the initial outlay. The new machine will be depreciated under MACRS using a five-
year recovery period. The firm has a 12 percent cost of capital and a 40 percent tax on ordinary
income and capital gains.
14) The payback period for the project is ________. (See Table 11.5)
A) 2 years
B) 3 years
C) between 3 and 4 years
D) between 4 and 5 years
15) The tax effect of the sale of the existing asset is ________. (See Table 11.5)
A) a tax liability of $2,340
B) a tax benefit of $1,500
C) a tax liability of $3,320
D) a tax liability of $5,320
16) The initial outlay for this project is ________. (See Table 11.5)
A) $42,820
B) $40,320
C) $47,820
D) $35,140
17) The present value of the project’s annual cash flows is ________. (See Table 11.5)
A) $47,820
B) $42,820
C) $51,635
D) $100,563
18) The net present value of the project is ________. (See Table 11.5)
A) $3,815
B) $2,445
C) $5,614
D) $7,500
19) The internal rate of return for the project is ________. (See Table 11.5)
A) between 7 and 8 percent
B) between 9 and 10 percent
C) greater than 12 percent
D) between 10 and 11 percent
20) Different projects have different levels of risk. As a result, the acceptance of a particular
project generally has an impact on a firm’s overall risk.
21) The acceptance of a particular project usually has no impact on a firm’s overall risk.
22) All projects should always use the WACC as the required return for capital budgeting
purposes.
23) Behavioral approaches for dealing with risk include scenario analysis and simulation.
24) Behavioral approaches for dealing with risk include annualized net present values and risk-
adjusted discount rates.
25) In capital budgeting, risk refers to the uncertainty surrounding the cash flows that a project
will generate and the degree of variability of project cash flows.
26) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will
provide conflicting recommendations to management.
27) The break even cash inflow is the minimum level of cash inflow necessary for a project to be
acceptable.
28) Projects with a small chance of being acceptable and a broad range of possible cash flows are
riskier than projects having a high chance of being acceptable and a narrow range of possible
cash flows.
29) In capital budgeting, risk refers to a high degree of variability of the initial investment of a
project.
30) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs
associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of
cash inflow.
31) Scenario analysis is a behavioral approach that evaluates the impact on a firm’s return
through simultaneous changes in a number of variables.
32) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses
the variability of returns.
33) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by
applying predetermined probability distributions and random numbers to estimate risky
outcomes.
34) The output of simulation provides an excellent basis for decision making since it allows the
decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.
35) Monte Carlo simulation programs usually build a histogram of the results.
36) Behavioral approaches ________.
A) are used to explicitly recognize project risk
B) are used to get a feel for project risk
C) are not used by rational financial managers
D) are used to quantify the risk
37) Breakeven cash inflow refers to ________.
A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV
greater than or equal to zero
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less
than zero
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less
than zero cost of capital
D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals
zero
38) In capital budgeting, risk refers to ________.
A) the chance that a project will prove acceptable
B) the conflicting IRR and NPV in a project
C) the degree of variability of initial outlay
D) the uncertainty of cash flows
39) In capital budgeting, risk refers to ________.
A) the degree of variability of the cash flows
B) the degree of variability of the initial investment
C) the chance that the net present value will be greater than zero
D) the chance that the internal rate of return will exceed the cost of capital
40) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in
project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash
inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the
project is ________.
A) $1,000,000
B) $131,474
C) $100,000
D) $66,667
Table 11.6
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts
have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows
which are given in the following table. The firm’s cost of capital is 10 percent.
41) The range of the annual cash inflows for Project A is ________. (See Table 11.6)
A) $30,000
B) $10,000
C) $5,000
D) $0
42) If the projects have five-year lives, the range of the net present value for Project B is
approximately ________. (See Table 11.6)
A) $80,563
B) $201,000
C) $255,444
D) $303,263
43) The expected net present value of Project A if the outcomes are equally probable and the
project has five-year life is ________. (See Table 11.6)
A) -$1,045
B) $17,910
C) $36,865
D) $93,730
44) A behavioral approach that evaluates the impact on a firm’s return through simultaneous
changes in a number variables of a project is called ________.
A) sensitivity analysis
B) scenario analysis
C) simulation analysis
D) Monte Carlo simulation
45) The advantage of using simulation in the capital budgeting process is the ________.
A) ease of calculation over scenario analysis
B) continuum of risk-return trade-offs for decision making
C) single point estimate that helps the decision maker to choose the most accurate alternative
D) use of several possible outcomes to asses risk
46) One type of simulation program made popular by the widespread use of personal computers
is called ________.
A) Monaco Simulation
B) Lemans Simulation
C) Cannes Simulation
D) Monte Carlo Simulation
1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the
percent of estimated cash inflows that investors would be satisfied to receive for certain rather
than the cash inflows that are possible for each year.
2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given
project to compensate a firm’s owners adequately, that is, to maintain or improve the firm’s share
price.
3) The security market line can be used as a graphical presentation of the appropriate discount
rate associated with each level of project risk.
4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.
5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount
rate (RADR) approach implicitly assumes that risk is an increasing function of time.
6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower
the net present value for a given stream of cash inflows.
7) For assets traded in an efficient market, the diversifiable risk can be eliminated through
diversification.
8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a
project’s beta and the market risk premium.