Corporate Finance, 3e (Berk/DeMarzo)
Chapter 8 Fundamentals of Capital Budgeting
8.1 Forecasting Earnings
1) Which of the following statements is FALSE?
A) A capital budget lists the projects and investments that a company plans to undertake during
the coming year.
B) Income Tax = EBIT × (1 – τc).
C) When sales of a new product displace sales of an existing product, the situation is often
referred to as cannibalization.
D) Overhead expenses are often allocated to the different business activities for accounting
purposes.
2) Which of the following statements is FALSE?
A) Sales will ultimately decline as the product nears obsolescence or faces increased
competition.
B) Managers sometimes continue to invest in a project that has a negative NPV because they
have already invested a large amount in the project and feel that by not continuing it, the prior
investment will wasted.
C) With straight-line depreciation the asset’s cost is divided equally over its life.
D) A projects unlevered net income is equal to its incremental revenues less costs and
depreciation, evaluated on an pre-tax basis.
3) Which of the following statements is FALSE?
A) We begin the capital budgeting process by determining the incremental earnings of a project.
B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of
pre-tax income.
C) Investments in plant, property, and equipment are directly listed as expense when calculating
earnings.
D) The opportunity cost of using a resource is the value it could have provided in its best
alternative use.
4) Which of the following statements is FALSE?
A) When evaluating a capital budgeting decision, the correct tax rate to use is the firm’s average
corporate tax rate.
B) To determine the capital budget, firms analyze alternative projects and decide which ones to
accept through a process called capital budgeting.
C) A new product typically has lower sales initially, as customers gradually become aware of the
product.
D) Sunk costs have been or will be paid regardless of the decision whether or not to proceed with
the project.
5) Which of the following statements is FALSE?
A) Because value is lost when a resource is used by another project, we should include the
opportunity cost as an incremental cost of the project.
B) Sunk costs are incremental with respect to the current decision regarding the project and
should be included in its analysis.
C) Overhead expenses are associated with activities that are not directly attributable to a single
business activity but instead affect many different areas of the corporation.
D) When computing the incremental earnings of an investment decision, we should include all
changes between the firm’s earnings with the project versus without the project.
6) Which of the following statements is FALSE?
A) The firm deducts a fraction of the investments in plant, property, and equipment each year as
depreciation.
B) If securities are fairly priced, the net present value of a fixed set of cash flows is independent
of how those cash flows are financed.
C) Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in
capital budgeting analysis.
D) A good rule to remember is that if our decision does not affect a cash flow then the cash flow
should not affect our decision.
7) Which of the following statements is FALSE?
A) The ultimate goal in capital budgeting is to determine the effect of the decision to take a
particular project on the firm’s cash flows.
B) To the extent that overhead costs are fixed and will be incurred in any case, they are
incremental to the project and should be included in the capital budgeting analysis.
C) Unlevered Net Income = (Revenue – Costs – Depreciation) × (1 – τc).
D) Earnings are not cash flows.
8) Which of the following statements is FALSE?
A) Project externalities are direct effects of the project that may increase of decrease the profits
of other business activities of the firm.
B) Incremental earnings are the amount by which the firm’s earnings are expected to change as a
result of the investment decision.
C) The average selling price of a product and its cost of production will generally change over
time.
D) Any money that has already been spent is a sunk cost and therefore irrelevant in the capital
budgeting process.
9) Which of the following statements is FALSE?
A) Many projects use a resource that the company already owns.
B) When evaluating a capital budgeting decision, we generally include interest expense.
C) Only include as incremental expenses in your capital budgeting analysis the additional
overhead expenses that arise because of the decision to take on the project.
D) As a practical matter, to derive the forecasted cash flows of a project, financial managers
often begin by forecasting earnings.
10) Which of the following statements is FALSE?
A) The simplest method used to calculate depreciation is the straight-line method.
B) A sunk cost is any unrecoverable cost for which the firm is already liable.
C) Unlevered Net Income = EBIT × τc.
D) The decision to continue or abandon should be based only on the incremental costs and
benefits of the project going forward.
11) Which of the following costs would you consider when making a capital budgeting decision?
A) Sunk cost
B) Opportunity cost
C) Interest expense
D) Fixed overhead cost
12) A decrease in the sales of a current project because of the launching of a new project is:
A) cannibalization.
B) a sunk cost.
C) an overhead expense.
D) irrelevant to the investment decision.
13) Money that has been or will be paid regardless of the decision whether or not to proceed with
the project is:
A) cannibalization.
B) considered as part of the initial investment in the project.
C) an opportunity cost.
D) a sunk cost.
14) The value of currently unused warehouse space that will be used as part of a new capital
budgeting project is:
A) an opportunity cost.
B) irrelevant to the investment decision.
C) an overhead expense.
D) a sunk cost.
Use the information for the question(s) below.
Ford Motor Company is considering launching a new line of Plug-in Electric SUVs. The heavy
advertising expenses associated with the new SUV launch would generate operating losses of
$35 million next year. Without the new SUV, Ford expects to earn pre-tax income of $80
million from operations next year. Ford pays a 30% tax rate on its pre-tax income.
15) The amount that Ford Motor Company owe in taxes next year without the launch of the new
SUV is closest to:
A) $24.0 million
B) $56.0 million
C) $31.5 million
D) $13.5 million
16) The amount that Ford Motor Company owe in taxes next year with the launch of the new
SUV is closest to:
A) $13.5 million
B) $31.5 million
C) $56.0 million
D) $24.0 million
Use the information for the question(s) below.
Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their
store. The firm expects that sales from the new one hour machine will be $150,000 per year.
FFL currently offers overnight film processing with annual sales of $100,000. While many of
the one hour photo sales will be to new customers, FFL estimates that 60% of their current
overnight photo customers will switch and use the one hour service.
17) The level of incremental sales associated with introducing the new one hour photo service is
closest to:
A) $90,000
B) $150,000
C) $60,000
D) $120,000
18) Suppose that of the 60% of FFL’s current overnight photo customers, half would start taking
their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour
service. The level of incremental sales in this case is closest to:
A) $60,000
B) $150,000
C) $90,000
D) $120,000
Use the information for the question(s) below.
Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000,
to diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The
cost of goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the
next year.
19) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales
over the next year by 30% to 130,000 units. The incremental impact of this price drop on the
firms EBIT is closest to:
A) a decline of 1.5 million.
B) an increase of 1.5 million.
C) a decline of 2.4 million.
D) an increase of 2.4 million.
20) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales
over the next year by 30% to 130,000 units. Also suppose that for each Glucoscan monitor sold,
GSI expects additional sales of $100 per year on glucose testing strips and these strips have a
gross profit margin of 75%. Considering the increase in the sale of testing strips, the incremental
impact of this price drop on the firms EBIT is closest to:
A) a decline of 1.5 million.
B) a decline of 0.7 million.
C) an increase of 0.7 million.
D) an increase of 1.5 million.
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that
has an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost
per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an
increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the
35% tax bracket, and has a cost of capital of 10%.
21) The incremental EBIT in the first year for the Sisyphean Corporation’s project is closest to:
A) $18,000
B) $8,000
C) $11,700
D) $5,200
22) The incremental unlevered net income in the first year for the Sisyphean Corporation’s
project is closest to:
A) $8,000
B) $18,000
C) $5,200
D) $11,700
23) The depreciation tax shield for the Sisyphean Corporation’s project in the first year is closest
to:
A) $8,000
B) $3,500
C) $2,800
D) $5,200
24) The amount of incremental income taxes that the Sisyphean Company will pay in the first
year on this new project is closest to:
A) $6,300
B) $5,200
C) $3,500
D) $2,800
25) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why
or why not?
26) What is an opportunity cost? Should it be included in the incremental cash flows for a
project? Why or why not?
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that
has an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost
per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an
increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the
35% tax bracket, and has a cost of capital of 10%.
27) Construct a simple income statement showing the incremental EBIT and the incremental
unlevered net income for all three years of the Sisyphean Companies project.
8.2 Determining Free Cash Flow and NPV
1) Which of the following statements is FALSE?
A) Depreciation is not a cash expense paid by the firm.
B) Net Working Capital = Cash + Inventory + Payables – Receivables.
C) Since 1997, companies can “carry back” losses for two years and “carry forward” losses for
20 years.
D) Earnings do not represent real profits.
2) Which of the following questions is FALSE?
A) Net Working Capital = Current Assets – Current Liabilities.
B) Because depreciation is not a cash flow, we do not include it in the cash flow forecast.
C) Tax loss carry backs allow corporations to take losses during the current year and use them to
offset income in future years.
D) Earnings are an accounting measure of firm performance.
3) Which of the following statements is FALSE?
A) Depreciation is a method used for accounting and tax purposes to allocate the original
purchase cost of the asset over its life.
B) Sometimes the firm explicitly forecast free cash flow over a shorter horizon than the full
horizon of the project or investment.
C) Earnings include the cost of capital investments, but do not include non-cash charges, such as
depreciation.
D) Firms often report a different depreciation expense for accounting and for tax purposes.
4) Which of the following statements is FALSE?
A) Most projects will require the firm to invest in net working capital.
B) The main components of net working capital are cash, inventory, receivables, and property,
plant and equipment.
C) ΔNWCt = NWCt – NWCt – 1.
D) In the final year of a project, the firm ultimately recovers the investment in net working
capital.
5) Which of the following statements is FALSE?
A) Depreciation expenses have a positive impact on free cash flow.
B) Free Cash Flow = (Revenues – Costs – Depreciation) × (1 – τc) – Capital Expenditures –
ΔNWC + τc × Depreciation.
C) The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay
dividends to shareholders.
D) The depreciation tax shield is the tax savings that results from the ability to deduct
depreciation.
6) Which of the following statements is FALSE?
A) Because only the tax consequences of depreciation are relevant for free cash flow, we should
use the depreciation expense that the firm will use for tax purposed in our free cash flow
forecasts.
B) A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into
based on its overall level of pre-tax income.
C) Free Cash Flow = (Revenues – Costs) × (1 – τc) – Capital Expenditures – ΔNWC + τc ×
Depreciation.
D) Net working capital is the difference between current liabilities and current assets.
7) Which of the following statements is FALSE?
A) The terminal of continuation value of the project represents the market value (as of the last
forecast period) of the free cash flow from the project at all future dates.
B) The incremental effect of a project on the firm’s available cash is the project’s free cash flow.
C) (1 – τc) × Depreciation is called the depreciation tax shield.
D) To evaluate a capital budgeting decision, we must determine its consequences for the firm’s
available cash.
8) Which of the following cash flows are relevant incremental cash flows for a project that you
are currently considering investing in?
A) The tax savings brought about by the project’s depreciation expense
B) The cost of a marketing survey you conducted to determine demand for the proposed project
C) Interest payments on debt used to finance the project
D) Research and Development expenditures you have made
9) Your firm is considering building a new office complex. Your firm already owns land
suitable for the new complex. The current book value of the land is $100,000, however a
commercial real estate again has informed you that an outside buyer is interested in purchasing
this land and would be willing to pay $650,000 for it. When calculating the NPV of your new
office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is:
A) $650,000
B) $0
C) $100,000
D) $750,000
10) You are considering adding a microbrewery on to one of your firm’s existing restaurants.
This will entail an increase in inventory of $8,000, an increase in Accounts payable of $2,500,
and an increase in property, plant, and equipment of $40,000. All other accounts will remain
unchanged. The change in net working capital resulting from the addition of the microbrewery
is:
A) $45,500
B) $10,500
C) $6,500
D) $5,500
11) You are considering adding a microbrewery on to one of your firm’s existing restaurants.
This will entail an investment of $40,000 in new equipment. This equipment will be depreciated
straight line over five years. If your firm’s marginal corporate tax rate is 35%, then what is the
value of the microbrewery’s depreciation tax shield in the first year of operation?
A) $2,800
B) $14,000
C) $5,200
D) $26,000
12) The Sisyphean Company is considering a new project that will have an annual depreciation
expense of $2.5 million. If Sisyphean’s marginal corporate tax rate is 40% and their average
corporate tax rate is 30%, then what is the value of the depreciation tax shield on their new
project?
A) $750,000
B) $1,000,000
C) $1,500,000
D) $1,750,000
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that
has an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost
per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an
increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the
35% tax bracket, and has a cost of capital of 10%.
13) The required net working capital in the first year for the Sisyphean Corporation’s project is
closest to:
A) $3,600
B) $3,960
C) $2,880
D) $5,400
14) The required net working capital in the second year for the Sisyphean Corporation’s project
is closest to:
A) $3,960
B) $4,360
C) $3.190
D) $5,940
15) The change in Net working capital from year one to year two is closest to:
A) A decrease of $360
B) An increase of $360
C) An increase of $396
D) A decrease of $396
16) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year.
The firm had depreciation expenses of $125 million and capital expenditures of $150 million.
Although they had no interest expense, the firm did have an increase in net working capital of
$20 million. What is Bubba Ho-Tep’s free cash flow?
A) $170 million
B) $255 million
C) $150 million
D) $5 million
Use the information for the question(s) below.
Temporary Housing Services Incorporated (THSI) is considering a project that involves setting
up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease
space in this facility to various agencies and groups providing relief services to the area. THSI
estimates that this project will initially cost $5 million to setup and will generate $20 million in
revenues during its first and only year in operation (paid in one year). Operating expenses are
expected to total $12 million during this year and depreciation expense will be another $3
million. THSI will require no working capital for this investment. THSI’s marginal tax rate is
35%.
17) Ignoring the original investment of $5 million, what is THSI‘s free cash flow for the first and
only year of operation?
A) $5.0 million
B) $3.75 million
C) $8.0 million
D) $6.25 million
18) Assume that THSI’s cost of capital for this project is 15%. The NPV of this temporary
housing project is closest to:
A) $435,000
B) -$650,000
C) $1,960,000
D) -$435,000
Use the information for the question(s) below.
Shepard Industries is evaluating a proposal to expand its current distribution facilities.
Management has projected the project will produce the following cash flows for the first two
years (in millions).
Year
1
2
Revenues
1200
1400
Operating Expense
450
525
Depreciation
240
280
Increase in working capital
60
70
Capital expenditures
300
350
Marginal corporate tax rate
30%
30%
19) The incremental EBIT for Shepard Industries in year one is closest to:
A) $360
B) $750
C) $595
D) $510
Revenues
– Expenses
= EBIT
20) The incremental EBIT for Shepard Industries in year two is closest to:
A) $415
B) $875
C) $595
D) $510
21) The incremental unlevered net income Shepard Industries in year one is closest to:
A) $510
B) $415
C) $600
D) $355