Chapter 14 – Capital investment decisions: the impact of capital rationing, taxation,
inflation and risk
MULTIPLE CHOICE
1. ____ is the process of altering key variables to assess the effect on the original outcome.
a.
Alteration analysis
b.
Experimentation
c.
Net present value
d.
Sensitivity analysis
2. Tax savings from tax allowable depreciation (i.e. writing down allowances) is calculated as
a.
Depreciation deduction Tax rate.
b.
Depreciation deduction (1 – Tax rate).
c.
Asset cost MACRS percentage.
d.
Depreciation is not a cash flow; therefore, there is no tax savings from depreciation.
3. A company has pre-tax cash inflows from operations of £500,000. If the company’s tax rate is 35 per
cent, the company’s after-tax net cash inflow from operations would be
a.
£166,667.
b.
£175,000.
c.
£325,000.
d.
£333,333.
4. If the tax rate is 35 per cent, a tax depreciation deduction (WDA)of £75,000 would result in a tax
savings of
a.
£25,000.
b.
£26,250.
c.
£48,750.
d.
£50,000.
5. If the tax rate is 40 per cent and a company has pre-tax cash inflows from operations of £600,000, the
company’s after-tax net cash inflow from operations would be
a.
£396,000.
b.
£360,000.
c.
£240,000.
d.
£204,000.
6. If an asset is sold for more than its tax written down value,
a.
a gain results and additional taxes are incurred.
b.
a gain and tax savings result.
c.
a loss results and additional taxes are incurred.
d.
a loss and tax savings result.
7. If an asset is sold for less than its tax written down value,
a.
a gain results and additional taxes are incurred.
b.
a gain and tax savings result.
c.
a loss results and additional taxes are incurred.
d.
a loss and tax savings result.
8. Houston Ltd.is considering an investment in equipment for £45,000. Data related to the investment are
as follows:
Cash Flow before
Year
Depreciation and Taxes
1
£30,000
2
30,000
3
30,000
4
30,000
5
30,000
Cost of capital is 18 per cent.
Houston claims capital allowances (WDV’s) using the straight-line method of depreciation. In
addition, their tax rate is 40 per cent, and the life of the equipment is five years with no salvage value.
What is the net present value of the investment?
a.
£67,543
b.
£22,543
c.
£48,810
d.
£11,286
9. Jolly Ltd.is considering an investment in equipment for £25,000. Data related to the investment are as
follows:
Cash Flow before
Year
Depreciation and Taxes
1
£12,500
2
12,500
3
12,500
4
12,500
Jolly claims capital allowances using the straight-line method of depreciation. In addition, its tax rate
is 40 per cent, and the life of the equipment is four years with no salvage value. Cost of capital is 12
per cent.
What is the net present value of the investment?
a.
£30,370
b.
£(2,222)
c.
£12,962
d.
£5,370
10. Springer Company is considering the purchase of a new machine for £80,000. The machine would
generate an annual cash flow before depreciation and taxes of £28,778 for five years. At the end of five
years, the machine would have no salvage value. The company’s cost of capital is 12 per cent. The
company claims capital allowances based on straight-line depreciation and has a 40 per cent tax rate.
What is the net present value for the machine?
a.
£5,318
b.
£-0-
c.
£85,318
d.
£23,744
11. Clemens Company is considering the purchase of a new machine for £160,000. The machine would
generate an annual cash flow before depreciation and taxes of £62,588 for four years. At the end of
four years, the machine would have no salvage value. The company’s cost of capital is 12 per cent. The
company claims capital allowances using straight-line depreciation and has a 40 per cent tax rate.
What is the net present value for the machine?
a.
£162,640
b.
£2,640
c.
£30,080
d.
(£45,952)
12. Young Company has a tax rate of 40 per cent. Information for the company is as follows:
Amount
After-tax Cost
Mortgage bonds
£1,000,000
0.048
Unsecured bonds
3,000,000
0.050
Common stock (ordinary share capital)
6,000,000
0.150
What is the weighted cost of capital?
a.
0.1098
b.
0.2480
c.
0.0827
d.
0.0366
13. Which of the following is included in calculating the weighted average cost of capital?
a.
interest rate paid on borrowed money
b.
average return earned by stockholders
c.
taxes
d.
all of the above
14. A firm has £2,000,000 of long-term bonds paying 8 per cent interest and £8,000,000 of common stock.
The firm is considered to be of average risk with the return to the stockholders estimated to be 14 per
cent. If the company’s tax rate is 40 per cent, what is the firm’s weighted average cost of capital?
a.
12.80%
b.
12.16%
c.
8.32%
d.
none of the above
Bonds
£ 2,000,000
0.20
Equity
Total
Weighted average cost of capital
15. A firm has £1,000,000 of long-term bonds paying 8 per cent interest and £3,000,000 of common stock.
The firm is considered to be of average risk with the return to the stockholders estimated to be 12 per
cent. If the company’s tax rate is 35 per cent, what is the firm’s weighted average cost of capital?
a.
11.00%
b.
7.15%
c.
10.30%
d.
none of the above
16. Which of the following is a common adjustment to net present value models to incorporate risks
inherent in an investment project?
a.
The discount rate used in the analysis can be increased.
b.
The payback period can be increased.
c.
A lower discount rate can be used.
d.
Risk is never considered in a model since it can not be quantified.
17. The depreciation tax shield is:
a.
the increase in taxes due to the deductibility of depreciation from taxable revenues.
b.
the reduction in taxes due to the deductibility of depreciation from taxable revenues.
c.
the fact that equipment is not depreciable for accounting purposes.
d.
the fact that equipment is not depreciable for tax purposes.
18. Which of the following is least likely to affect taxes as a result of a capital budgeting decision?
a.
an increase in operating income
b.
the disposition of an old asset that is fully depreciated and worthless
c.
salvage value of a new asset
d.
depreciation of a new asset
19. The annual tax deduction for depreciation:
a.
is not accompanied by a direct cash outlay.
b.
provides an indirect cash inflow by reducing taxes.
c.
multiplied by the tax rate equals the depreciation tax shield (i.e. the tax benefit from
capital allowances.
d.
all of the above
20. A follow-up analysis of an investment decision is called a(n)
a.
performance review.
b.
feedback session.
c.
audit.
d.
postaudit.
21. Why should a company conduct postaudits of its investment projects?
a.
It ensures that investment resources were used wisely.
b.
Accountable managers would make goal-congruent decisions.
c.
It provides feedback for future decision making.
d.
all of the above
22. A postaudit compares
a.
estimated benefits and costs with budgeted benefits and cost.
b.
estimated benefits with estimated costs.
c.
actual benefits with actual costs.
d.
actual benefits and costs with estimated benefits and costs.
SHORT ANSWER
1. What are some of the types of sources of risk that a typical capital expenditures project can entail?
PROBLEM
1. Ramsey Construction is considering the purchase of a backhoe for £300,000. The expected life is 4
years. The company uses the straight-line method of depreciation with no mid-year convention. The
company’s tax rate is 34 per cent. The present value factors at the company’s cost of capital are as
follows:
Period
Present Value of £1.00
1
0.86
2
0.74
3
0.64
4
0.55
5
0.48
Required:
Determine the present value of the tax shield (i.e. tax benefits) assuming that capital allowances are
based on the straight-line method. Present your answer in good format.
2. Redding Industries is considering the acquisition of a new machine that would reduce operating costs
by £100,000 per year throughout its life. The machine has a cost of £300,000 and has an expected
salvage value of £25,000 at the end of 4 years. The tax shield (i.e. tax savings) from capital allowances
is £34,000; £45,344; £15,111; and £7,555 for Years 1-4, respectively. The company is at the 34 per
cent tax rate. The present value factors at the company’s required rate of return are as follows:
Period
Present Value of £1.00
1
0.88
2
0.77
3
0.68
4
0.59
Required:
(Round all calculations to the nearest pound.)
a.
Compute the after-tax operating cost savings per year.
b.
Determine the tax cost or tax savings related to the sale of the machine at the end of its useful
life.
c.
Prepare a schedule computing the net present value of Redding Industries’ investment in the
machine.
After-tax cost savings = £100,000 (1 – 0.34) = £66,000
Straight-Line:
