Part 6 Long-Term Investment Decisions
CHAPTER 14
CASH FLOW ESTIMATION AND CAPITAL BUDGETING
DECISIONS
CHAPTER LEARNING OBJECTIVES
14.1 Outline the basic framework for capital expenditure analysis.
14.2 Estimate the future cash flows associated with potential investments.
14.3 Explain how to make replacement decisions, and explain what is special about
them.
14.4 Conduct a sensitivity analysis to see how the value changes as key inputs
14.5 Explain how mistakes can easily be made when dealing with inflation.
Cash Flow Estimations and Capital Budgeting Decisions 14 – 2
MULTIPLE CHOICE QUESTIONS
1. Which of the following is NOT appropriate for estimating the cash flows associated with capital
expenditure decisions?
a) Discount nominal cash flows with nominal discount rates, and real cash flows with real discount
rates.
b) Include associated interest and dividend payments.
c) Use after-tax cash flows with an after-tax discount rate.
d) Use the marginal or incremental cash flows arising from capital budgeting decisions.
2. Which of the following should NOT be considered in the capital budgeting decision?
a) Working capital requirements.
b) Initial cash outlay.
c) Opportunity costs.
d) Sunk costs.
3. Which of the following should be accounted for in the capital budgeting decision?
a) Externalities.
b) Intangible considerations that cannot be measured.
c) Opportunity costs.
d) Sunk costs.
4. Which of the following should be ignored in the capital budgeting decision?
a) The effect of all project interdependencies.
b) Social investments required by law.
c) Inflation.
d) Externalities.
5. Incremental cash flows are of primary interest in capital budgeting decisions because:
a) they are more relevant than intangible costs and benefits.
b) they are able to correct for a portion of the uncertainty due to the long time horizon.
c) the change in the company’s future cash flows is what is being estimated.
d) they are the easiest cash flows to identify.
6. Which of the following is NOT an incremental cash flow?
a) Research and development costs for the new product, which have already been undertaken.
b) Reduction in sales of an existing product line as a result of the introduction of the new product
line.
c) Cannibalization
d) Proceeds from the sale of old equipment.
7. A firm is considering a project that has cash flows indexed to the consumer price index. What
discount rate should be chosen?
a) Nominal discount rate
b) Yield to maturity
Cash Flow Estimations and Capital Budgeting Decisions 14 – 4
c) Change in consumer price index
d) A rate that uses the consumer price index in its measure
8. Which of the following is NOT an example of cannibalization?
a) Kellogg’s introduces a new type of cereal.
b) Ford rolls out a new model of car.
c) Molson brings out a new beer.
d) Canadian Tire allows Tim Horton’s to operate a concession stand in their retail outlets.
9. Use the following statements to answer this question:
I. When we are dealing with cannibalization of a project, we should ignore the old product.
II. Increases in incremental cash flows can be gained from decreases in expenses.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
d) I is incorrect and II is correct.
10. A Canadian oil company is considering whether or not to develop a site it has been exploring
for the past six months. One of the arguments for developing the site is that considerable time and
money have already been expended. This cost should not be included in the capital budgeting
decision because it is:
a) an opportunity cost.
b) a sunk cost.
c) an operating cost
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d) a financing cost
11. A company is considering taking over a firm that has a very good company image. The
company image cannot be assessed in financial terms and has no direct link to the change in cash
flows. How can we categorize the company’s image?
a) Opportunity cost
b) Sunk Cost
c) Externality
d) Intangible
12. The incremental cash flows for a project are estimated as:
a) accounting profit before taxes.
b) cash flows before taxes.
c) cash flows after taxes.
13. A real estate company started the exploration of buying a piece of land for condos. The
company bought the land and started breaking ground. The housing market crashed, and the
amount spent may not be recovered completely. What do we call the costs involved with the
development of the land?
a) An opportunity cost.
b) A sunk cost.
c) An incremental cost
d) A financing cost
Cash Flow Estimations and Capital Budgeting Decisions 14 – 6
14. A real estate company started the exploration of buying a piece of land for condos. The
company bought the land and started breaking ground. The housing market crashed, and the
amount spent may not be recovered completely. What do we call the costs involved with the
purchase of the land?
a) An opportunity cost.
b) A sunk cost.
c) An incremental cost
d) A financing cost
15. A pharmaceutical company has discovered a new drug that treats gastrointestinal disorders. In
the testing phase of this new drug, the company further discovered that the drug is effective
against migraine headaches. The R&D costs for the drug were $3 million. When evaluating the
capital budgeting decision for the migraine remedy, what portion of the R&D costs for the drug
should be attributed to the migraine budget?
a) 0 percent of the R&D costs.
b) 50 percent of the R&D costs.
c) 100 percent of the R&D costs.
d) It cannot be determined until the drug is further tested. There may be more uses for this drug
and further testing is required.
16. A pharmaceutical company has discovered a new drug that treats gastrointestinal disorders.
The R&D costs for the drug were $3 million. In the testing phase of this new drug, the company
further discovered that there is a possibility that the drug would be effective against migraine
headaches if they invest another 10% in R&D. When evaluating the capital budgeting decision for
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the migraine remedy, what portion of the R&D costs for the drug should be attributed to the
migraine budget?
a) 0 percent of the R&D costs.
b) $300,000 of the R&D costs.
c) $1.65 million of the R&D costs.
d) It cannot be determined until the drug is further tested. There may be more uses for this drug
and further testing is required.
17. Which of the following would NOT be included in a capital budgeting evaluation?
a) Incremental cash flows
b) External benefits
c) Effects of price level changes
d) Taxes
18. Which of the following would be considered relevant cash flows in a capital budgeting
evaluation?
I. Increased after-tax income.
II. Tax savings due to increased depreciation expense.
III. Increased expenditures on inventory for the new project.
IV. Benefits that accrue to the local community.
a) I, II, and III.
b) I, II, and IV.
c) I, III, and IV.
d) I, II, III, and IV.
19. Which of the following statements is correct?
a) Investment in net working capital is not depreciated because it is a sunk cost:
b) Investment in net working capital is not depreciated because it is not a depreciable asset.
c) Investment in net working capital is not depreciated because it is not an operating cash flow.
d) all of the above.
20. Which of the following is NOT relevant to the cash flow estimates that are associated with a
project?
a) The associated financing costs.
b) The economic life of the project.
c) The effect of inflation.
d) The terminal cash flow.
21. Use the following two statements to answer this question:
I. The initial after-tax cash flow refers to the total cash outlay that is required to initiate an
investment project and can be depreciated for tax purposes.
II. The capital cost of an investment refers to all costs incurred to make an investment operational,
which includes the additional working capital requirements.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.
22. Which of the following is correct with respect to working capital and capital budgeting?
a) Working capital is ignored in the capital budget.
b) Working capital has a different discount rate.
c) Working capital is assumed to be recuperated at the end of the life of the project.
d) Working capital does not affect cash flow.
23. If the asset is depreciated completely before the end of the life of the project, what happens to
the salvage value?
a) The salvage value is ignored in the capital budget.
b) The salvage value is amortized further.
c) The after-tax salvage value is discounted at the date of the disposal of the asset.
d) The asset’s life is extended.
24. Which of the following is NOT a component of the initial after-tax cash flow?
a) The change in the net working capital requirements.
b) The initial capital cost of the asset.
c) The original cost of a capital asset that was incurred several years ago.
d) The opportunity costs associated with the project.
25. According to Canada Revenue Agency:
I. The purchase cost of a capital asset is to be capitalized and its value expensed as depreciation
expense over future periods.
II. The modification costs of a capital asset have to be expensed immediately.
Cash Flow Estimations and Capital Budgeting Decisions 14 – 10
a) I and II are correct.
b) I and II are incorrect.
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.
26. What is the difference between the initial cash flow and the purchase price of an asset?
a) Set up costs only
b) Capital costs
c) Other capital costs and net working capital
d) None of the above
27. Which of the following is NOT a component of the expected annual after-tax cash flows?
a) The additional depreciation expense that results from the capital cost of the investment.
b) The additional taxes paid that result from the capital budgeting decision.
c) The incremental increase in after-tax operating income of the project.
d) The incremental tax savings that result from the initial investment outlay.
28. The following equation (𝑆𝑉−𝐶0)𝑇
(1+𝑘)𝑡 is:
a) Present value of the salvage value.
b) Present value of the terminal value of the asset.
c) Present value of the taxes owed on the gain resulting from the sale of an asset.
d) The present value of the depreciation.
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29. Because CCA is a non-cash expense, in estimating the annual after-tax cash flows, we have to
deal with it using one of the following two approaches:
I. Deduct CCA from operating income, then deduct the associated taxes payable, and finally add
the amount of the CCA tax savings back.
II. Multiply the CCA by the company’s effective tax rate and add this amount to the after-tax
operating income.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.
30. Why do we add the present value of the CCA tax shield to the NPV?
a) Tax shield is a cost.
b) The CAA tax shield arises from depreciating the asset.
c) The CCA tax shield arises from expensing the interest.
d) None of the above
31. Use the following two statements to answer this question:
I. The use of declining balance CCA means that the tax deductions last forever and the asset is
never fully depreciated.
II. The half-year rule results in CCA expense that is lower in year 1 and highest in year 2.
a) I and II are correct.
b) I and II are incorrect.
Cash Flow Estimations and Capital Budgeting Decisions 14 – 12
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.
32. Which of the following is NOT a true statement?
a) A capital loss arises when the selling price of a depreciable asset is lower than the original
purchase price.
b) A capital gain arises when the selling price of an asset is greater than the original capital cost.
c) CCA recapture occurs when the salvage value of an asset exceeds the UCC and selling the
asset terminates the CCA asset class.
d) A terminal loss occurs when the salvage value of an asset is less than the ending UCC and
selling the asset terminates the CCA asset class.
33. Which of the following is most likely to occur upon termination of a project?
a) Capital gains
b) CCA recapture
c) Terminal losses
d) Working capital recapture
34. Montreal Sun Printing is looking at an opportunity of setting up a new production facility, which
requires the purchase of a new printing press that costs $1 million. The costs to install the machine
are $60,000. The new facility is to be built on a piece of land that the company bought for $150,000
five years ago. The market value of the land is $250,000. The R&D costs associated with the
investment opportunity were $50,000. In addition, the company will need to purchase $40,000
additional inventory for the project use. What is the initial after-tax cash flow associated with the
investment opportunity?
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a) $1,250,000
b) $1,300,000
c) $1,350,000
d) $1,400,000
35. Montreal Sun Printing is looking at an opportunity of setting up a new production facility, which
requires the purchase of a new printing press that costs $1 million. The costs to install the machine
are $60,000. The new facility is to be built on a piece of land that the company bought for $150,000
five years ago. The market value of the land is $250,000. The R&D costs associated with the
investment opportunity were $50,000. In addition, the company will need to purchase $40,000
additional inventory for the project use. How much of these costs can be categorized as a sunk
cost?
a) $250,000
b) $60,000
c) $50,000
d) None of the above
36. La Montrealaise Transportation Company is considering a project, which requires the purchase
of a fleet of trucks costing $500,000. It will need to spend $65,000 to modify the trucks before they
can be put into operation. The associated opportunity costs are $35,000. In addition, the company
will need to spend $10,000 on additional spare parts inventory. What is the initial capital cost
associated with the investment opportunity?
a) $500,000
b) $565,000
c) $575,000
d) $610,000
Cash Flow Estimations and Capital Budgeting Decisions 14 – 14
37. Given the following information on a project: initial capital cost = $500,000; installation costs
associated with the capital asset = $25,000; R&D costs associated with the project = $50,000;
associated opportunity costs = $80,000; increase in raw materials inventory = $10,000, what is the
initial cash outlay of the project?
a) $535,000
b) $590,000
c) $615,000
d) $665,000
38. Given the following information on a project: initial capital cost = $500,000; installation costs
associated with the capital asset = $25,000; R&D costs associated with the project = $50,000;
associated opportunity costs = $80,000; increase in raw materials inventory = $10,000, which of
these amounts is included with working capital?
a) $500,000
b) $80,000
c) $10,000
d) $25,000
39. La Poutine Cheese Products Inc. is considering a project that requires an initial cash outlay of
$290,000, comprised of $235,000 for the purchase of new equipment, $13,000 for the installation
costs, and $42,000 for additional inventory. In addition, the R&D associated with the project was
$5,000 and its opportunity costs are $28,000. What is the capital cost associated with the
investment opportunity?
a) $235,000
b) $248,000
c) $290,000
d) $318,000
40. Which one of the following represents the change in net working capital?
a) The level of inventory in the project.
b) The difference between the account receivables at the end and beginning of the project.
c) The difference between the account payables at the end and beginning of the project.
d) The difference between current assets and current liabilities.
41. Unique Style Inc. is considering a five-year expansion project that requires an initial investment
of $500,000 for the purchase of a new machine with a CCA rate of 30 percent. The projected sales
revenue and related costs are $450,000 and $180,000 per year, respectively. The project’s fixed
costs are an additional $48,000 per year. The appropriate discount rate is 8 percent. The firm’s
marginal tax rate is 40 percent. What is the after-tax cash flow in year three?
a) $162,600
b) $168,900
c) $191,400
d) $197,700
42. The following information was reported last year:
Beginning Ending
Accounts receivable $85,250 $75,338
Accounts payable $72,362 $55,124
Inventory $51,225 $63,037
What was the effect of the change in net working capital on cash flow for the year?
Cash Flow Estimations and Capital Budgeting Decisions 14 – 16
a) –$19,138
b) –$15,338
c) $19,138
d) $15,338
43. The following information was reported last year:
Beginning Ending
Accounts receivable $65,250 $75,338
Accounts payable $42,362 $55,124
Inventory $51,225 $51,225
What was the change in net working capital for the year?
a) $2,674
b) –$22,850
c) –$2,674
d) $–$22,850
44. The following information is from last year’s financial statements:
Beginning Ending
Inventory $80,233 $71,169
Accounts Receivable $73,489 $64,508
Accounts Payable $55,332 $42,256
What was the net cash flow if the reported sales revenue and costs for the same period were
$582,366 and $437,265, respectively?
a) $113,980
b) $140,132
c) $150,070
d) $176,222
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45. Champlain Transportation Inc. is considering a five-year project that requires an initial capital
investment of $1 million. The project is expected to generate operating revenue of $500,000 per
year, and the associated operating expenses are estimated at $250,000 per year. The capital
asset belongs to asset class 9, which has a CCA rate of 30 percent. The firm’s marginal tax rate is
35 percent. What is the after-tax cash flow for year 1?
a) $215,000
b) $267,500
c) $302,500
d) $312,500
46. Champlain Transportation Inc. is considering a six-year project that requires $800,000 for the
purchase of a capital asset with a CCA rate of 30 percent. The project is expected to generate
sales revenue of $600,000 per year. The project’s variable and fixed costs are estimated at
$240,000 and $50,000 per year, respectively. The firm’s marginal tax rate is 35 percent and cost of
capital is 12 percent. What is the present value of the after-tax operating cash flows?
a) $828,449
b) $962,069
c) $1,274,536
d) $1,480,107
47. Toronto Skates Corp. is considering a five-year project that requires an initial investment of
$250,000. The project is expected to generate operating incomes of $60,000 in year 1, $90,000 in
year 2, $150,000 in year 3, $100,000 in year 4, and $80,000 in year 5. The asset belongs to asset
Cash Flow Estimations and Capital Budgeting Decisions 14 – 18
class 7, which has a CCA rate of 15 percent. The firm’s marginal tax rate is 35 percent and cost of
capital is 10 percent. What is the present value of the after-tax operating cash flows?
a) $205,272
b) $233,739
c) $315,804
d) $359,598
48. BC Travel Services is considering a new ten-year project that will generate additional sales
revenue of $200,000 per year. The associated costs are $120,000 per year. The project is
somewhat riskier than the company’s current operations, and hence requires a risk premium of 2
percent. The company’s cost of capital is 12 percent and marginal tax rate is 40 percent. What is
the present value of the after-tax operating cash flows?
a) $250,374
b) $271,211
c) $417,289
d) $452,018
49. Monteregie Auto Services is considering an opportunity to invest $550,000 in a capital asset
that will generate additional after-tax operating income of $200,000 per year. The asset has a six-
year life, a CCA rate of 20 percent, and an expected salvage value of $60,000. The project has a
beta of 1.5. The company’s cost of capital is 12 percent and marginal tax rate is 35 percent. The
risk-free rate is 4.5 percent and the market risk premium is 6 percent. What is the present value of
the after-tax operating cash flows?
a) $512,526
b) $534,483
c) $788,501
d) $822,281
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50. Canadian Donuts is looking at a new investment opportunity, which will require the purchase of
a capital asset of $1 million and additional raw materials inventory of $50,000. The project is
expected to generate operating revenue of $750,000 per year, and the associated operating
expenses are estimated at $350,000 per year. The project has a five-year economic life. This
capital asset belongs to asset class 8, which has a CCA rate of 20 percent. What is the CCA
expense for year 3?
a) $115,200
b) $128,000
c) $144,000
d) $180,000
51. Maple Syrup Food is considering a six-year expansion project that requires an initial
investment of $350,000 for the purchase of a new capital asset with a CCA rate of 20 percent. The
costs to install the asset are $25,000. The projected annual sales revenue and costs are $200,000
and $90,000 per year, respectively. The appropriate discount rate is 10 percent. The firm’s
marginal tax rate is 40 percent. What is the fourth year CCA expense?
a) $35,840
b) $38,400
c) $40,320
d) $43,200
52. The Beer Brewing Company is interested in a new eight-year project. The project calls for an
initial cash outlay of $1,000,000: $850,000 for new equipment, $100,000 for installation costs, and
$50,000 for additional net working capital. The asset has a CCA rate of 30 percent and an
Cash Flow Estimations and Capital Budgeting Decisions 14 – 20
expected salvage value of $75,000. The project will generate additional operating profit of
$325,000 per year. What is the UCC at the end of year 3?
a) $395,675
b) $325,850
c) $354,025
d) $416,500
53. Hull Small Business is considering an expansion project that requires $135,000 for the
purchase of capital assets and $35,000 for additional inventory. The project will generate after-tax
operating income of $50,000 per year. The project has a five-year economic life and a CCA rate of
20 percent. What is the ending UCC upon termination of the project?
a) $44,237
b) $49,766
c) $55,706
d) $62,669
54. Laurentide Resort Corporation is considering a seven-year project that requires an initial
investment of $525,000 and generates annual after-tax operating cash flow of $225,000. The asset
has a CCA rate of 30 percent and an expected salvage value of $65,000. The firm’s marginal tax
rate is 40 percent. What is the CCA tax savings for year 5?
a) $15,126
b) $18,368
c) $37,816
d) $45,919