Chapter 10—CAPITAL BUDGETING AND CASH FLOW ANALYSIS
MULTIPLE CHOICE
1. The value of resources used in an investment project should be measured in terms of their
a.
acquisition cost
b.
historical cost
c.
opportunity cost
d.
depreciated cost
2. Sale of an asset for less than book value creates an operating loss which effectively reduces the
company’s taxes by an amount equal to ____ times ____.
a.
one-half the loss, the company’s marginal tax rate
b.
the loss, one minus the company’s marginal tax rate
c.
one-half the loss, one minus the company’s marginal tax rate
d.
the loss, the company’s marginal tax rate
3. There is neither a gain or a loss on the sale of a depreciable asset for an amount exactly equal to its
____.
a.
acquisition cost
b.
tax book value
c.
opportunity cost
d.
historical cost
4. Which of the following would not be classified as a capital expenditure for decision-making purposes?
a.
purchase of a building
b.
investment in a management training program
c.
purchase of 90-day Treasury Bills
d.
development of a major advertising campaign
5. A firm’s cost of capital is:
a.
an important financial ratio
b.
equal to 10 percent
c.
rarely used in practice
d.
an important input in the capital budgeting process
6. Which of the following is a basic principle when estimating a project’s cash flows?
a.
cash flows should be measured on a pretax basis
b.
cash flows should ignore depreciation because it is a non-cash charge
c.
only direct effects of a project should be included in cash flow calculations
d.
cash flows should be measured on an incremental basis
7. Which of the following items is not considered as a part of the net investment calculation?
a.
the first year’s net cash flow
b.
increase in net working capital
c.
salvage of an old piece of equipment that is being replaced
d.
installation and shipping charges
8. The effect of a one dollar increase in depreciation expenses is to ____ the typical firm’s net cash flows
by ____ one dollar.
a.
increase, less than
b.
increase, exactly
c.
decrease, more than
d.
increase, more than
9. The dollar amount of interest charges is:
a.
always considered in the net cash flow calculation
b.
normally not considered in the net cash flow calculation
c.
always considered as a part of the net investment
d.
None of these answers are correct.
10. Determining the net investment (NINV) of a project includes explicit consideration of all of the
following except:
a.
estimated net cash flow
b.
project cost plus installation and shipping costs
c.
increases in net working capital
d.
taxes associated with the sale of an existing asset and/or the purchase of a new one
11. The determination of net cash flows (NCF) should never include
a.
changes in depreciation
b.
changes in operating costs
c.
interest charges
d.
changes in depreciation or operating costs
12. Cash flows for all investment projects should be projected over the ____ of the project.
a.
MACRS recovery period
b.
depreciable life
c.
economic life
d.
smaller of depreciable or economic lives
13. When a firm sells an asset for ____, it realizes a capital gain and must pay income taxes on it.
a.
book value
b.
less than book value
c.
more than book value but less than original cost
d.
more than its original cost
14. In estimating the net investment, an outlay that has already been made is known as a (n) ____.
a.
sunk cost
b.
cash outflow
c.
opportunity cost
d.
expansion cost
15. Depreciation is based on the asset cost plus all of the following except
a.
shipping costs
b.
increase in inventory
c.
installation
d.
cost of attached equipment acquired at the same time
16. Depreciation ____ reported profits and it ____ taxes paid by a firm.
a.
increases, reduces
b.
reduces, reduces
c.
reduces, increases
d.
increases, increases
17. If a firm sells an asset for less than its book value,
a.
there are no tax consequences
b.
the loss is treated as lost depreciation
c.
the loss reduces depreciation expenses
d.
the loss may be used to offset operating income
18. The ____ the amount of depreciation charged in a period, the ____ will be the firm’s taxable income.
a.
greater, lower
b.
lower, lower
c.
lower, higher
d.
greater, higher
19. In terms of the capital budgeting process, net cash flows are
a.
the net cash outlays required to place a project in service
b.
the funds invested in additional assets
c.
incremental changes in a firm’s cash flow
d.
the outlays that have already been made
20. Depreciation
a.
does not affect cash flows
b.
does not affect profits
c.
is not a cash outflow
d.
is a cash inflow
21. The capital budgeting process is very important to the firm because it:
a.
highlights the impacts of a project on net income
b.
essentially plots the company’s future direction
c.
is used in working capital analysis
d.
indicates the net cash flows available for employee education
22. A (n) ____ is a cash outlay that is expected to generate a flow of future cash benefits lasting longer
than 1 year.
a.
depreciation charge
b.
operating expenditure
c.
capital expenditure
d.
sunk cost
23. The net cash flows for any year during the life of capital expenditure project are equal to the change in
____ plus the change in ____.
a.
earnings before interest and taxes; depreciation
b.
earnings before taxes; depreciation
c.
earnings after taxes; depreciation
d.
revenues; costs
24. The net investment calculation for an ____ project normally includes ____.
a.
asset expansion; pretax proceeds from the sale of the old asset
b.
asset replacement; pretax proceeds from the sale of the old asset
c.
asset expansion; after-tax proceeds from the sale of the old asset
d.
asset replacement; after-tax proceeds from the sale of the old asset
25. There is a capital gain on the sale of an asset for ____.
a.
more than its original cost
b.
more than its book value but less than its original cost
c.
more than its original cost and book value
d.
All of these answers could be correct.
26. The net investment calculation for an asset replacement decision normally includes any ____.
a.
after-tax salvage value of the old asset
b.
increase in net working capital
c.
after-tax salvage value of the old asset and increase in net working capital
d.
cannot be determined from the information given.
27. When calculating the net cash flow in a project’s expected final year,
a.
recovery of any working capital invested is disregarded
b.
the after-tax salvage value of any project equipment is considered
c.
the remaining principal on any borrowed funds is considered
d.
the sales proceeds from any land associated with the project is disregarded
28. ____ have cash flow patterns with more than one sign change.
a.
Conventional projects
b.
Non-normal projects
c.
Normal projects
d.
Contingent projects
29. A drill press costs $30,000 and is expected to have a 10 year life. The drill press will be depreciated on
a straight-line basis over 10 years to a zero estimated salvage value. This machine is expected to
reduce the firm’s cash operating costs by $4,500 per year. If the firm is in the 40 percent marginal tax
bracket, determine the annual net cash flows generated by the drill press.
a.
$4,500
b.
$900
c.
$5,700
d.
$3,900
30. An investment project is expected to generate earnings before taxes (EBT) of $60,000 per year.
Annual depreciation from the project is $30,000 and the firm’s tax rate is 40 percent. Determine the
project’s annual net cash flows.
a.
$48,000
b.
$66,000
c.
$36,000
d.
$12,000
31. Ten years ago J-Bar Company purchased a lathe for $250,000. It was being depreciated on a straight-
line basis to an estimated $25,000 salvage value over a 15-year period. The firm is considering selling
the old lathe and purchasing a new one that would cost $500,000. The firm’s marginal tax rate is 40
percent. Determine the net investment required to purchase the new lathe, if the old lathe is sold for
$100,000.
a.
$380,000
b.
$397,500
c.
$400,000
d.
$200,000
32. In Step Video is considering expanding its video rental library to 8,000 tapes. The purchase price of
the additional videos will be $80,000 and the shipping cost is another $4,000. To house the tapes, the
owner will have to spend another $10,000 for display shelves, increase net working capital by $5,000,
and interest expenses will add another $8,000 to the operating cost. What is the net investment to In
Step Video for this project?
a.
$95,000
b.
$99,000
c.
$84,000
d.
$107,000
33. What is the net investment for an extruder that costs $42,000 if shipping costs are $1,500 and
installation is $4,800? Assume this efficient machine is replacing an older extruder with a book and
market value of zero. The replacement investment will reduce operating costs by $6,600 a year.
a.
$48,300
b.
$54,900
c.
$43,500
d.
None of these are correct.
34. Shunt Technology will spend $800,000 on a piece of equipment that will manufacture fine wire for the
electronics industries. The shipping and installation charges will be $240,000 and net working capital
will increase $48,000.The equipment will replace an existing machine that has a salvage value of
$75,000 and a book value of $125,000. If Shunt has a current marginal tax rate of 34 percent, what is
the net investment?
a.
$1,030,000
b.
$1,163,000
c.
$1,033,000
d.
$996,000
35. Capital Foods purchased an oven 5 years ago for $45,000. The oven is being depreciated over its
estimated 10-year life using the straight line method to a salvage value of $5,000. Capital is planning
to replace the oven with a more automated one that will cost $150,000 installed. If the old oven can be
sold for $30,000, what is the tax liability? Assume a marginal tax rate of 40 percent.
a.
$900
b.
$2,000
c.
$127,000
d.
$6,000
36. The management of Jasper Equipment Company is planning to purchase a new milling machine that
will cost $160,000 installed. The old milling machine has been fully depreciated, but can be sold for
$15,000. The new machine will be depreciated on a straight line basis over its 10-year economic life to
an estimated salvage value of $10,000. If the milling machine will save Jasper $20,000 a year in
production expenses, what are the annual net cash flows associated with the purchase of this machine?
Assume a marginal tax rate of 40 percent.
a.
$15,000
b.
$18,000
c.
$27,000
d.
$58,000
37. Jim Bo’s currently has annual cash revenues of $240,000 and annual operating expenses of $185,000
including $35,000 in depreciation. The firm’s marginal tax rate is 40 percent. A new cutting machine
can be purchased for $120,000 that will increase revenues by $50,000 per year while operating
expenses would increase to $205,000, including $42,000 in depreciation. Compute Jim Bo’s annual
incremental after-tax net cash flows.
a.
$25,000
b.
$20,800
c.
$93,000
d.
$19,000
38. Moon Pie Company is considering automated baking equipment that costs $500,000 installed and
would replace the present hand-made production method. The present equipment has a zero book and
salvage value. The new equipment will not increase revenues but will reduce operating costs from a
current level of $600,000 to $300,000 per year. The depreciation of the new equipment will be
$73,000 per year. What are the annual incremental net cash flows? Assume a marginal tax rate of 40
percent.
a.
$296,800
b.
$136,200
c.
$192,200
d.
$209,200
39. LISP Inc. is planning to purchase a new mixer/dubber for $50,000. The new equipment will replace an
older mixer that has been fully depreciated but has a salvage value of $5,000. Compute the net
investment required for this project. Assume a marginal tax rate of 40 percent.
a.
$47,000
b.
$45,000
c.
$48,000
d.
$55,000
40. What is the net investment required for a pitting machine that will cost $35,000 including installation?
The machine replaces a machine that cost $5,000 when purchased five years ago. The old machine has
been fully depreciated but has a market value of $6,000. Assume the marginal tax rate is 40 percent.
a.
$29,000
b.
$31,400
c.
$32,600
d.
$11,600
41. Allen Company is considering an investment project that is expected to generate $100,000 in annual
earnings before taxes. Annual depreciation will be $50,000. Allen’s marginal tax rate is 40%.
Determine the project’s annual net cash flows.
a.
$150,000
b.
$110,000
c.
$90,000
d.
$60,000
42. Baker Company is considering an investment in a new metal lathe. If the new lathe is purchased,
revenues will increase by $5,000 per year and cash operating costs will decline by $10,000 per year.
The lathe will cost $60,000 and will be depreciated on a straight-line basis over 10 years to a zero
estimated salvage value. Baker’s marginal tax rate is 40%. Determine the annual net cash flows
generated by the lathe.
a.
$11,400
b.
$9,000
c.
$600
d.
$5,400
43. Basin Manufacturing is considering a plant expansion project. The equipment will cost $100,000 and
will require an additional $10,000 for delivery and installation. The expansion also will require Basin
to increase immediately its net working capital by $25,000. The expansion is expected to generate
revenues of $150,000 per year, and its marginal tax rate is 40%. Calculate the project’s net investment.
a.
$ 81,000
b.
$125,000
c.
$131,000
d.
$135,000
44. Rupp Pumps is purchasing an extruder for $80,000. The extruder will require an expenditure of
$12,000 for installation and $4,000 for training new operators. The new equipment will require an
increase of $5,000 in inventory, $4,000 in accounts receivable, and $3,000 in accounts payable. What
is the net investment for this project?
a.
$108,000
b.
$102,000
c.
$ 98,000
d.
$ 99,000
45. Felix Industries purchased a grinder 5 years ago for $15,000. It is being depreciated on a straight-line
basis over 15 years to an estimated salvage value of zero. It could be sold now for $6,000. The firm is
considering selling it and purchasing a new one. The new grinder would cost $25,000 installed and
would be depreciated on a straight-line basis over 10 years to a zero estimated salvage value. The
company’s marginal tax rate is 40%. Determine the net investment if the old grinder is sold and the
new one purchased.
a.
$19,000
b.
$16,600
c.
$17,400
d.
Cannot be computed from the information provided
46. Anderson Clayton will purchase a new pellet mill that replace an older, less efficient, mill. The new
mill costs $360,000 and shipping costs are $10,000. Improving the steam lines to the new mill will
cost an additional $22,000. The old mill has a book value of $25,000 and can be sold for $12,000. The
installation of the new mill will cause inventories to increase by $8,000, accounts receivable will go up
$20,000, and accounts payable will increase $10,000. If Anderson Clayton has a marginal tax rate of
40%, what is the NINV for the new mill?
a.
$392,800
b.
$412,800
c.
$374,800
d.
$398,000
47. Com-Cat is considering expanding its production facility. This year Com-Cat had an operating income
(EBIT) of $760,000, interest expenses of $120,000, depreciation expenses of $45,000, and capital
expenditures of $160,000. Next year, after the expansion is completed, operating income is expected to
be $880,000, interest expenses will remain at $120,000, but depreciation will increase to $61,000. To
support the expansion, cash is to expected to increase by $5,000, accounts receivable by $12,000,
inventories by $8,000, and accounts payable by $7,000. What is the change in Com-Cat’s net operating
cash flows attributable to this project, if the tax rate is 40%?
a.
$80,400
b.
$88,000
c.
$106,000
d.
$70,000
48. The net present value and the internal rate of return methods of determining the acceptance or rejection
of projects may result in different outcomes. This is because of:
a.
The source of the capital used to purchase the asset.
b.
The life expectancy of the asset.
c.
The reinvestment rate assumption
d.
The type of industry that is considering the purchase.
ESSAY
1. What is a capital expenditure and list some examples.
2. Explain the problems associated with cash flow estimation and how can they be alleviated?
