Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 11 Cash Flows and Other Topics in Capital Budgeting
11.1 Learning Objective 1
1) Accounting profits are used to make capital budgeting decisions because generally accepted
accounting principles ensure that profits are the best measure of a company’s economic activity.
2) Capital budgeting decisions are based on free cash flow because free cash flow better reflects
when money is received and available for reinvestment than account profits.
3) The guiding rule in deciding if a free cash flow is incremental is to look at the company with,
versus without, the new project.
4) A grocery store decides to offer beer for sale and this decision results in more potato chip
sales. This is an example of a synergistic effect.
5) Additional investment in working capital, even if it may be recovered at the end of a project,
must be included in capital budgeting analysis because of the time value of money.
6) Sunk costs are cash outflows that will occur regardless of the current accept/reject decision,
and therefore should be excluded from the analysis.
7) Overhead costs are sometimes incremental cash flows and other times are considered sunk
costs.
8) Interest payments on a loan obtained specifically to fund a new project should be considered
an incremental cash flow for the new project when determining the accept/reject decision.
9) To be included in a capital budgeting analysis, all incremental free cash flows must be
expensed on the company’s books, otherwise generally accepted accounting principles will be
violated.
10) In measuring cash flows we are interested only in the incremental or incremental after-tax
cash flows that are attributed to the investment proposal being evaluated.
11) The initial outlay for a new project is an example of an opportunity cost.
12) Synergistic benefits from an investment project include cannibalism.
13) A project’s annual free cash flow is the change in operating cash flow less any change in net
working capital and less any change in capital spending.
14) Toyota’s capital budgeting analysis for the Prius, a gas-electric hybrid, was faulty because
the car line has not made a profit to date.
15) Accounting profits, adjusted for taxes and differences in accounting methods, provide the
best measure of relevant cash flows for capital budgeting purposes.
16) Hershy’s expects to sell $2 million of its new candy bar, although $200,000 of this amount
would have been spent on its existing candy bar. The $2 million is the appropriate cash inflow
for the new candy bar project, while the $200,000 will be counted against the return on the old
candy bar.
17) Adding gourmet coffee stations to my convenience store is expected to increase sales of my
breakfast sandwiches; however, the sales of breakfast sandwiches should not be included in the
evaluation of the gourmet coffee project because only relevant, incremental cash flows should be
considered.
18) As a rule, any cash flows that are not affected by the accept/reject criterion should not be
included in capital-budgeting analysis.
19) If a project uses an asset the corporation already owns, the cost of that asset for capital
budgeting purposes is zero to reflect the advantage the project has over projects that require the
purchase of new assets.
20) For companies in competitive markets, the evolution and introduction of new products may
serve more to preserve market share than to expand it.
21) The calculation of incremental free cash flows over a project’s life should include
A) labor and material saving.
B) additional revenue.
C) interest to bondholders.
D) A and B.
22) Eastlick Dairy invests in a new kind of frozen dessert called polar cream that becomes very
popular. So many new customers come to the store that the sales of existing ice cream products
are increased. The extra sales revenue
A) should not be counted as incremental revenue for the polar cream project because the sales
come from existing products.
B) are synergistic effects that should be counted as incremental revenues for the polar cream
project.
C) are cannibalized sales that should be excluded from the analysis.
D) should be included in the analysis, but not the cost of the ice cream that is sold as that is a
recurring expense.
23) Sunk costs are
A) recoverable.
B) incremental.
C) not relevant in capital budgeting.
D) not deductible for tax purposes.
24) Snow Fun Corporation is considering a new product line. The company currently
manufactures several lines of snow skiing apparel. The new products, insulated ski bikinis, are
expected to generate sales of $1.2 million per year for the next five years. They expect that
during this five-year period, they will lose about $150,000 each year in sales on their existing
lines of longer ski pants. The new line will require no additional equipment or space in the plant
and can be produced in the same manner as the apparel products. The new project will, however,
require that the company spend an additional $50,000 per year on insurance in case customers
sue for frostbite. Also, a new marketing director would be hired to oversee the line at $75,000
per year in salary and benefits. Because of the different construction of the bikinis, an increase in
inventory of $9,000 would be required initially. If the marginal tax rate is 35%, compute the
incremental after tax cash flows for years 1-5.
A) $634,500 per year
B) $625,000 per year
C) $601,250 per year
D) $537,500 per year
11.2 Learning Objective 2
1) In general, a project’s free cash flows will fall in one of the following three categories: initial
outlay, differential cash flows over the project’s life, and the terminal cash flow.
2) If an old asset is sold for less than its book value the resulting loss will save the company
taxes, hence lowering the cost of the project.
3) If an old asset is sold for its depreciated, or book, value, then no taxes result and there is no
tax effect from the sale.
4) One example of a terminal cash flow is the recapture of the net working capital associated
with the project.
5) The initial outlay of a project may be reduced by the after-tax salvage value of replaced
equipment.
6) A weakness in the capital budgeting process is the funds for an investment proposal obtained
by issuing bonds, and the respective interest payments, are not considered in the capital
budgeting process.
7) The initial outlay includes the immediate cash outflow necessary to purchase the asset and put
it in operating order.
8) If the increase in net working capital is recovered entirely at the end of the project then it may
be ignored.
9) Cash flows associated with a project’s termination generally include the salvage value of the
project net of any taxes associated with the sale.
10) Increasing depreciation expense results in a decrease of the incremental after-tax free cash
flow.
11) Increases in working capital needs should be included as part of the initial outlay of a project,
but decreases in working capital for a project should not be considered because they are not
guaranteed.
12) Any increase in interest payments caused by a project should be counted in the incremental
cash flows.
13) Terminal cash flows are always positive because they result from the shutting down of a
project with the sale of any assets with remaining value.
14) Proceeds from the issuance of new debt and principal payments upon maturity of debt used
to finance a project should be included in the calculation of the project’s after-tax cash flows.
15) Interest payments on debt are not included in a project’s incremental cash flows, but are
instead accounted for in the project’s discount rate.
16) Depreciation is a non-cash deduction so it may be ignored in the calculation of a project’s
incremental after-tax cash flows.
17) Depreciation expense produces a cash inflow equal to the depreciation expense multiplied by
the firm’s marginal tax rate.
18) TRL, Inc. has spent $2,000,000 in nonrefundable engineering fees in contemplation of
building a convention center and the additional costs to complete the project are $18,000,000.
The present value of all benefits the center will produce in its lifetime are $19,000,000, so TRL
should not build the convention center.
19) Free cash flow calculations can be broken down into three parts: cash flows from operations,
cash flows associated with working-capital requirements, and financing cash flows relating to
interest and dividend payments.
20) An opportunity cost is a relevant incremental cost for capital budgeting decisions.
21) Capital budgeting projects that expand sales are more likely to involve increases in working
capital than are projects that involve the replacement of existing assets.
22) Increases in inventory and accounts receivable expected to occur if a proposed advertising
campaign is undertaken are examples of sunk costs.
23) In general, a project’s free cash flows will fall into one of three categories: (1) incremental
costs, (2) sunk costs, and (3) opportunity costs.
24) The initial outlay includes the cost of purchasing the asset and getting it operational,
including the purchase price, shipping and installation, and any training costs for employees who
will be operating the equipment, and any increases in working capital requirements.
25) The initial outlay includes the cost of purchasing the asset and getting is operational, but this
excludes any training costs for employees which should be included as part of differential cash
flows over the life of the project.
26) In a replacement decision, the initial outlay is equal to the cost of the new asset less the
reduction in depreciation from elimination of the old asset.
27) Operating cash flow is equal to the change in EBIT less the change in interest expense, less
the change in taxes, plus the change in depreciation.
28) Changes in capital spending are not incorporated directly into capital budgeting problems
because the amounts are included in the operating cash flows through the inclusion of
depreciation expense.
29) A project’s annual free cash flow is the change in operating cash flow less any change in net
working capital and less any change in capital spending.
30) Taste Good Chocolates develops a new candy bar and plans to sell each bar for $1. Taste
Good predicts that 1 million candy bars will be sold in the first year if the new candy bar is
produced and sold, and includes $1 million of incremental revenues in its capital budgeting
analysis. A senior executive in the company believes that 1 million candy bars will be sold, but
lowers the estimate of incremental revenue to $700,000. What would explain this change?
A) cannibalization of 300,000 of Taste Good Chocolates’ other candy bars
B) excessive marketing costs to sell the 1 million candy bars
C) a lower discount rate
D) a higher selling price for the new candy bars
31) Laural Inc. is a household products firm that is considering developing a new detergent. In
evaluating whether to go ahead with the new detergent project, which of the following
statements is most correct?
A) The company will produce the detergent in a building that they already own. The cost of the
building is therefore zero and should be excluded from the analysis.
B) The company will need to use some equipment that it could have leased to another company.
This equipment lease could have generated $200,000 per year in after-tax income. The $200,000
should be excluded because the equipment can no longer be leased.
C) The company will need to hire 10 new workers whose salaries and benefits will total
$400,000 per year. Labor costs are not part of capital budgeting and should be excluded.
D) The company will produce the detergent in a building that it renovated 2 years ago for
$300,000. The $300,000 should be excluded from the analysis.
32) JW Enterprises is considering a new marketing campaign that will require the addition of a
new computer programmer and new software. The programmer will occupy an office in JW’s
current building and will be paid $8,000 per month. The software license costs $1,000 per
month. The rent for the building is $4,000 per month. JW’s computer system is always on, so
running the new software will not change the current monthly electric bill of $900. The
incremental expenses for the new marketing campaign are
A) $13,900 per month.
B) $9,000 per month.
C) $13,000 per month.
D) $8,000 per month.
33) A local restaurant owner is considering expanding into another urban area. The expansion
project will be financed through a line of credit with First National Bank. The administrative
costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000
per month. The new restaurant will occupy an existing building that can be rented for $2,500 per
month. The incremental cash flows for the new restaurant include
A) $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent.
B) $500 administrative costs, $2,500 per month rent.
C) $1,000 per month interest payments, $2,500 per month rent.
D) $2,500 per month rent.
34) Margo Inc. wants to replace a 9-year-old machine with a new machine that is more efficient.
The old machine cost $70,000 when new and has a current book value of $15,000. Margo can
sell the machine to a foreign buyer for $14,000. Margo’s tax rate is 35%. The effect of the sale of
the old machine on the initial outlay for the new machine is
A) ($14,350).
B) ($13,650).
C) ($9,100).
D) $1,000
35) You are analyzing the purchase of new equipment. Since you are not an expert on this type
of equipment, you hire a consulting firm to make recommendations. The consultant charged you
$1,500 and recommended the purchase of the latest model from Equipment Corp. of America.
The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by
your firm. The equipment will be depreciated on a straight-line basis over six years with no
salvage value. You expect the equipment will be sold after three years for $28,000. Use of the
equipment will require an increase in your company’s net working capital of $4,000, but this
$4,000 will be recovered at the end of year three. The use of the equipment will have no effect
on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs.
Your company’s marginal tax rate is 35%. What is the initial outlay required to fund this project?
A) $80,000
B) $84,000
C) $90,000
D) $94,000
36) You are analyzing the purchase of new equipment. Since you are not an expert on this type
of equipment, you hire a consulting firm to make recommendations. The consultant charged you
$1,500 and recommended the purchase of the latest model from Equipment Corp. of America.
The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by
your firm. The equipment will be depreciated on a straight-line basis over six years with no
salvage value. You expect the equipment will be sold after three years for $28,000. Use of the
equipment will require an increase in your company’s net working capital of $4,000, but this
$4,000 will be recovered at the end of year three. The use of the equipment will have no effect
on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs.
Your company’s marginal tax rate is 35%. What is the incremental free cash flow for the first
year of the project?
A) $23,800
B) $29,850
C) $32,440
D) $37,750
37) You are analyzing the purchase of new equipment. Since you are not an expert on this type
of equipment, you hire a consulting firm to make recommendations. The consultant charged you
$1,500 and recommended the purchase of the latest model from Equipment Corp. of America.
The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by
your firm. The equipment will be depreciated on a straight-line basis over six years with no
salvage value. You expect the equipment will be sold after three years for $28,000. Use of the
equipment will require an increase in your company’s net working capital of $4,000, but this
$4,000 will be recovered at the end of year three. The use of the equipment will have no effect
on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs.
Your company’s marginal tax rate is 35%. What is the terminal cash flow for this project?
A) ($17,000)
B) $24,500
C) $33,950
D) $37,950
38) A new project is expected to generate $800,000 in revenues, $250,000 in cash operating
expenses, and depreciation expense of $150,000 in each year of its 10-year life. The
corporation’s tax rate is 35%. The project will require an increase in net working capital of
$85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the free
cash flow from the project in year one?
A) $298,000
B) $375,000
C) $380,000
D) $410,000
39) Jones Company expects the following results in year one of a new project:
Revenue $400,000
Cash Expenses 150,000
Depreciation 90,000
EBIT $160,000
Taxes 48,000
Net Income $112,000
The annual change in operating cash flow is equal to
A) $298,000.
B) $202,000.
C) $160,000.
D) $250,000.
40) Your company is considering the replacement of an old delivery van with a new one that is
more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is
being depreciated using the simplified straight-line method over a useful life of 8 years. The old
van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will
cost $6,000 to modify the van to carry the company’s products. Cost savings from use of the
new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for
its estimated salvage value of $18,000. The new van will be depreciated using the simplified
straight-line method over its 5-year useful life. The company’s tax rate is 35%. Working capital
is expected to increase by $5,000 at the inception of the project, but this amount will be
recaptured at the end of year five. What is the incremental free cash flow for year one?
A) $18,875
B) $19,985
C) $22,305
D) $24,220
41) Your company is considering the replacement of an old delivery van with a new one that is
more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is
being depreciated using the simplified straight-line method over a useful life of 8 years. The old
van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will
cost $6,000 to modify the van to carry the company’s products. Cost savings from use of the
new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for
its estimated salvage value of $18,000. The new van will be depreciated using the simplified
straight-line method over its 5-year useful life. The company’s tax rate is 35%. Working capital
is expected to increase by $5,000 at the inception of the project, but this amount will be
recaptured at the end of year five. What is the terminal cash flow?
A) $23,000
B) $18,000
C) $17,250
D) $16,700
42) The recapture of net working capital at the end of a project will
A) increase terminal year free cash flow.
B) decrease terminal year free cash flow by the change in net working capital times the corporate
tax rate.
C) increase terminal year free cash flow by the change in net working capital times the corporate
tax rate.
D) have no effect on the terminal year free cash flow because the net working capital change has
already been included in a prior year.
43) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase
sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do
more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be
increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by
$4,000 per month. An example of a synergistic effect from the new diagnostic testing procedure
is the
A) increase in inventory levels of oil and brake parts.
B) increase in revenue of $10,000 per month for the diagnostic testing.
C) increase in revenues from oil changes and brake jobs of $4,000 per month.
D) increase in all activities totaling $19,000 per month.
44) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase
sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do
more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be
increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by
$4,000 per month. An example of an increase in net working capital requirements from the new
diagnostic testing procedure is the
A) increase in inventory levels of oil and brake parts of $5,000.
B) increase in revenue of $10,000 per month for the diagnostic testing.
C) increase in revenues from oil changes and brake jobs of $4,000 per month.
D) increase in all activities totaling $19,000 per month.
45) If depreciation expense in year one of a project increases for a highly profitable company,
A) net income decreases and incremental free cash flow decreases.
B) net income increases and incremental free cash flow increases.
C) the book value of the depreciating asset increases at the end of year one.
D) net income decreases and incremental free cash flow increases.
46) Salvage value would most likely not be considered by
A) net present value.
B) internal rate of return.
C) payback.
D) A and B.
47) Which of the following cash flows are not considered in the calculation of the initial outlay
for a capital investment proposal?
A) increase in accounts receivable
B) cost of issuing new bonds if the project is financed by a new bond issue
C) installation costs
D) none of the above – all are considered
48) Which of the following is NOT considered in the calculation of incremental cash flows?
A) tax saving due to increased depreciation expense
B) interest payments if new debt is issued
C) increased dividend payments if additional preferred stock is issued
D) B and C
49) A project for Jevon and Aaron, Inc. results in additional accounts receivable of $400,000,
additional inventory of $180,000, and additional accounts payable of $70,000. What is the
additional investment in net working capital?
A) $580,000
B) $510,000
C) $270,000
D) $150,000
50) Project XYZ requires an investment in equipment of $600,000 to replace existing equipment.
The existing equipment will produce after-tax salvage value of $70,000. Net working capital
requirements are increased by $50,000. What is the total cash outflow at time zero?
A) $720,000
B) $650,000
C) $530,000
D) $580,000
51) A six-year project for East Nile, Inc. results in additional accounts receivable of $150,000,
additional inventory of $50,000, and additional accounts payable of $80,000 today. What is the
change in the NPV of a project solely due to the additional net working capital (NWC) needs?
Assume a 14% discount rate, and the recovery of net working capital at the end of the project.
A) a decrease of $34,606
B) a decrease of $42,670
C) a decrease of $120,000
D) a decrease of $58,689
52) Which of the following should be included in the initial outlay?
A) taxable gain on the sale of old equipment being replaced
B) first year depreciation expense on any new equipment purchased
C) preexisting firm overhead reallocated to the new project
D) increased investment in inventory and accounts receivable
53) Increased depreciation expenses affect tax-related cash flows by
A) increasing taxable income, thus increasing taxes.
B) decreasing taxable income, thus reducing taxes.
C) decreasing taxable income, with no effect on cash flow since depreciation is a non-cash
expense.
D) pushing a corporation into a higher tax bracket.
54) Which of the following are included in the terminal cash flow?
A) the expected salvage value of the asset
B) any tax payments or receipts associated with the salvage value of the asset
C) recapture of any working capital increase included in the initial outlay
D) all of the above
55) J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000
for shipping and another $7,000 to get the machine integrated with the company’s existing assets.
J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The
company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-
line basis over its expected useful life of 8 years. What will depreciation expense be during the
first year?
A) $13,000
B) $12,500
C) $11,625
D) $11,500
56) J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000
for shipping and another $7,000 to get the machine integrated with the company’s existing assets.
J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The
company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-
line basis over its expected useful life of 8 years. J.B. is replacing an old machine that was
purchased 6 years ago for $50,000. The old machine was being depreciated on a straight-line
basis over a ten year expected useful life. The machine was sold for $15,000. J.B.’s marginal tax
rate is 40%. What is the amount of the initial outlay?
A) $89,000
B) $87,000
C) $91,000
D) $85,000
57) When terminating a project for capital budgeting purposes, the working capital outlay
required at the initiation of the project will
A) not affect the cash flow.
B) decrease the cash flow because it is a historical cost.
C) increase the cash flow because it is recaptured.
D) decrease the cash flow because it is an outlay.
58) J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000
for shipping and another $7,000 to get the machine integrated with the company’s existing assets.
J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The
company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-
line basis over its expected useful life of 8 years. Which of the following statements concerning
the change in working capital is most accurate?
A) The $4,000 paid for oil is added to the initial outlay, offset by the tax savings $1600.
B) The $4,000 may be expensed each year over the life of the project as part of the incremental
free cash flows.
C) The $4,000 is added to the initial outlay and recaptured during the terminal year, hence
having no impact on the projects NPV or IRR.
D) Even if the $4,000 is fully recovered at the end of the project, the project’s NPV and IRR will
be lower if the change in working capital is included in the analysis.
59) XYZ company is considering replacing an old machine with a new one. Two months ago
their chief engineer completed a training seminar on the new machine’s operation and efficiency.
The $3,000 cost for this training session has already been paid. If the new machine is purchased,
it would require $7,000 in installation and modification costs to make it suitable for operation in
the factory. The old machine originally cost $80,000 five years ago and is being depreciated by
$10,000 per year. The new machine will cost $100,000 before installation and modification. It
will be depreciated by $12,000 per year. The old machine can be sold today for $12,000. The
marginal tax rate for the firm is 40%. Compute the relevant initial outlay in this capital budgeting
decision.
A) $79,500
B) $97,800
C) $90,800
D) $87,800
60) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was
purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine
is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs
$100,000. It will cost the company $10,000 to get the new lathe to the factory and get it
installed. The old machine will be sold as scrap metal for $2,000. The new machine is also
being depreciated on a straight-line basis over ten years. Sales are expected to increase by
$8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF’s
marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new
machine and higher sales level. The initial outlay for the new machine is
A) $113,000.
B) $112,200.
C) $111,000.
D) $109,800.
61) The financial manager selecting one of two projects of differing risk should
A) select the project with the larger risk-adjusted net present value.
B) choose the project with the least relative risk.
C) choose the project with greater return even if that project has greater risk.
D) choose the project with less risk even though that project has less return.
62) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was
purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine
is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs
$100,000. It will cost the company $10,000 to get the new lathe to the factory and get it
installed. The old machine will be sold as scrap metal for $2,000. The new machine is also
being depreciated on a straight-line basis over ten years. Sales are expected to increase by
$8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF’s
marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new
machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the
project’s ten-year life. What is the incremental free cash flow during year 1 of the project?
A) $12,800
B) $14,400
C) $11,400
D) $15,200
63) Incremental cash flows refer to
A) the difference between after-tax cash flows and before-tax accounting profits.
B) the new cash flows that will be generated if a project is undertaken.
C) the cash flows of a project, minus financing costs.
D) the cash flows that are foregone if a firm does not undertake a project.
64) Which of the following should be included in an analysis of a new project’s cash flows?
A) Any sales from existing products that would be lost if customers were expected to purchase a
new product instead.
B) All financing costs.
C) All sunk costs.
D) No opportunity costs.
65) It is important to consider a new project’s affect on the cash flows of existing projects
because of
A) cannibalism.
B) synergy.
C) sunk costs.
D) A and B above.