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Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
LOCAL STANDARDS:
United States - OH - Default City - TBA
TOPICS:
Net working capital
39. The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and
cash flows higher, during every year of a project's life, other things held constant.
a.
True
b.
False
ANSWER:
False
40. Which of the following statements is CORRECT?
a.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives
are 5 years or longer.
b.
Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder
reporting and tax purposes.
c.
Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting
decisions.
d.
Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early
cash flows and thus lowers a project's projected NPV.
e.
Using accelerated depreciation rather than straight line would normally have no effect on a project's total
projected cash flows but it would affect the timing of the cash flows and thus the NPV.
ANSWER:
e
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Page 22
41. Which of the following statements is CORRECT?
a.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives
are 5 years or longer.
b.
Corporations must use the same depreciation method for both stockholder reporting and tax purposes.
c.
Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and
thus increasing a project's forecasted NPV.
d.
Using accelerated depreciation rather than straight line normally has no effect on a project's total projected
cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project.
e.
Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from
investing in the asset.
ANSWER:
c
42. Which of the following statements is CORRECT?
a.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives
are 3 years or longer.
b.
If firms use accelerated depreciation, they will write off assets slower than they would under straight-line
depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line
depreciation were required for tax purposes.
c.
If they use accelerated depreciation, firms can write off assets faster than they could under straight-line
depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line
depreciation were required for tax purposes.
d.
If they use accelerated depreciation, firms can write off assets faster than they could under straight-line
depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
depreciation were required for tax purposes.
e.
Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant
input, depreciation plays no role in capital budgeting.
ANSWER:
d
43. To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is
CORRECT?
a.
Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating
the operating cash flows.
b.
When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk
costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the
discounting process.
c.
Capital budgeting decisions should be based on before-tax cash flows.
d.
The cost of capital used to discount cash flows in a capital budgeting analysis should be calculated on a
before-tax basis.
e.
In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest
expense, because financing costs are accounted for by discounting at the cost of capital. If interest were
deducted when estimating cash flows, this would, in effect, "double count" it.
ANSWER:
e
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44. Which of the following statements is CORRECT?
a.
Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the
reported accounting profits, and thus reported accounting income should be used as the basis for investor and
managerial decisions.
b.
It is unrealistic to believe that any increases in net working capital required at the start of an expansion project
can be recovered at the project's completion. Working capital like inventory is almost always used up in
operations. Thus, cash flows associated with working capital should be included only at the start of a project's
life.
c.
If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in
a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset
had been sold at book value, other things held constant.
d.
Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-
term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital
budgeting analysis.
e.
If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm,
hence its terminal cash flow will be negative.
ANSWER:
c
45. You have just landed an internship in the CFO's office of Hawkesworth Inc. Your first task is to estimate the Year 1
cash flow for a project with the following data. What is the Year 1 cash flow?
Sales revenues
$13,000
Depreciation
$4,000
Other operating costs
$6,000
Tax rate
35.0%
a.
$5,950
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
b.
$6,099
c.
$6,251
d.
$6,407
e.
$6,568
ANSWER:
a
46. In your first job with TBL Inc. your task is to consider a new project whose data are shown below. What is the
project's Year 1 cash flow?
Sales revenues
$22,250
Depreciation
$8,000
Other operating costs
$12,000
Tax rate
35.0%
a.
$8,903
b.
$9,179
c.
$9,463
d.
$9,746
e.
$10,039
ANSWER:
c
47. Fitzgerald Computers is considering a new project whose data are shown below. The required equipment has a 3-year
tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and
other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?
Equipment cost (depreciable basis)
$65,000
Straight-line depreciation rate
33.333%
Sales revenues, each year
$60,000
Operating costs (excl. deprec.)
$25,000
Tax rate
35.0%
a.
$28,115
b.
$28,836
c.
$29,575
d.
$30,333
e.
$31,092
ANSWER:
d
48. VR Corporation has the opportunity to invest in a new project, the details of which are shown below. What is the Year
1 cash flow for the project?
Sales revenues, each year
$42,500
Depreciation
$10,000
Other operating costs
$17,000
Interest expense
$4,000
Tax rate
35.0%
a.
$16,351
b.
$17,212
c.
$18,118
d.
$19,071
e.
$20,075
ANSWER:
e
49. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What is the
project's Year 1 cash flow?
Sales revenues, each year
$62,500
Depreciation
$8,000
Other operating costs
$25,000
Interest expense
$8,000
Tax rate
35.0%
a.
$25,816
b.
$27,175
c.
$28,534
d.
$29,960
e.
$31,458
ANSWER:
b
50. Your new employer, Freeman Software, is considering a new project whose data are shown below. The equipment
that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33.33%, 44.45%,
14.81%, and 7.41% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the
project's 10-year expected life. What is the Year 1 cash flow?
Equipment cost (depreciable basis)
$65,000
Sales revenues, each year
$60,000
Operating costs (excl. deprec.)
$25,000
Tax rate
35.0%
a.
$30,333
b.
$31,849
c.
$33,442
d.
$35,114
e.
$36,869
ANSWER:
a
51. Whitestone Products is considering a new project whose data are shown below. The required equipment has a 3-year
tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4.
Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is
the project's Year 4 cash flow?
Equipment cost (depreciable basis)
$70,000
Sales revenues, each year
$42,500
Operating costs (excl. deprec.)
$25,000
Tax rate
35.0%
a.
$11,904
b.
$12,531
c.
$13,190
d.
$13,850
e.
$14,542
ANSWER:
c
52. DeVault Services recently hired you as a consultant to help with its capital budgeting process. The company is
considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be
depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital
would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is
the project's NPV?
Risk-adjusted cost of capital
10.0%
Net investment cost (depreciable basis)
$65,000
Straight-line deprec. rate
33.3333%
Sales revenues, each year
$65,500
Operating costs (excl. deprec.), each year
$25,000
Tax rate
35.0%
a.
$15,740
b.
$16,569
c.
$17,441
d.
$18,359
e.
$19,325
ANSWER:
e
53. Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an
end. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment
today for $6,000, and its tax rate is 40%. What is the equipment's after-tax salvage value for use in a capital budgeting
analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a
result of the sale.
a.
$5,558
b.
$5,850
c.
$6,143
d.
$6,450
e.
$6,772
ANSWER:
b
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54. McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation.
The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to
operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax
salvage value be when the machine is sold at the end of Year 4?
Year
Depreciation Rate
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
a.
$8,878
b.
$9,345
c.
$9,837
d.
$10,355
e.
$10,900
POINTS:
1
55. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below. The
equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage
value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over
the project's 3-year life. However, this project would compete with other Weston's products and would reduce their pre-
tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
Cost of capital
10.0%
Pre-tax cash flow reduction for other products (cannibalization)
$5,000
Investment cost (depreciable basis)
$80,000
Straight-line deprec. rate
33.333%
Sales revenues, each year for 3 years
$67,500
Annual operating costs (excl. deprec.)
$25,000
Tax rate
35.0%
a.
$3,636
b.
$3,828
c.
$4,019
d.
$4,220
e.
$4,431
ANSWER:
b
56. Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the
building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The
equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it
would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and
revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash
flows are constant in Years 1-3.)
Project cost of capital (r)
10.0%
Opportunity cost
$100,000
Net equipment cost (depreciable basis)
$65,000
Straight-line deprec. rate for equipment
33.333%
Sales revenues, each year
$123,000
Operating costs (excl. deprec.), each year
$25,000
Tax rate
35%
a.
$10,521
b.
$11,075
c.
$11,658
d.
$12,271
e.
$12,885
ANSWER:
d
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
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Page 36
POINTS:
1
57. Garden-Grow Products is considering a new investment whose data are shown below. The equipment would be
depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some
additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are
expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)
Project cost of capital (r)
10.0%
Net investment in fixed assets (basis)
$75,000
Required new working capital
$15,000
Straight-line deprec. rate
33.333%
Sales revenues, each year
$75,000
Operating costs (excl. deprec.), each year
$25,000
Tax rate
35.0%
a.
$23,852
b.
$25,045
c.
$26,297
d.
$27,612
Chapter 13: Capital Budgeting: Estimating Cash Flows and Analyzing Risk
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Page 37
e.
$28,993
POINTS:
1
58. Sheridan Films is considering some new equipment whose data are shown below. The equipment has a 3-year tax life
and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value
at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it
would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the
project's 3-year life. What is the project's NPV?
Project cost of capital (r)
10.0%
Net investment in fixed assets (depreciable basis)
$70,000
Required new working capital
$10,000
Straight-line deprec. rate
33.333%
Sales revenues, each year
$75,000
Operating costs (excl. deprec.), each year
$30,000
Expected pretax salvage value
$5,000
Tax rate
35.0%
a.
$20,762
