Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 8 Making Capital Investment Decisions
1) Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe
to now be manufactured, the firm will need to expand into an empty building that it currently
owns. The firm was offered $229,000 last week for that building. An additional $342,000 will be
required for new equipment and building improvements. Labor and material costs are estimated at
$4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new
shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs?
A) $229,000 value of the building
B) $134,000 for research
C) $229,000 value of the building plus $342,000 for new equipment and improvements
D) $17,800 for interest plus $134,000 for research
E) $229,000 for the building plus $134,000 for research
2) Bloomfield’s has some idle equipment that is debt-free and also fully depreciated. If the
company decides to use this equipment for a new project, what cost, if any, should be included for
this equipment in the project’s start-up costs?
A) Zero cost
B) Original purchase price of the equipment
C) Original purchase price minus any tax savings realized to date on the depreciation
D) Current market value of the equipment
E) Annual storage cost for the equipment
3) The most valuable investment given up if an alternative investment is chosen is referred to as
a(n)
A) sunk cost.
B) opportunity cost.
C) salvage value expense.
D) equivalent annual cost.
E) erosion cost.
4) The cash flows of a new project that come at the expense of a firm’s existing projects are called
A) opportunity costs.
B) net working capital expenses.
C) erosion costs.
D) salvage value expenses.
E) sunk costs.
5) Which one of these statements is correct?
A) All allocated costs should be included in the initial cost of a project.
B) Sunk costs should be included in the initial cost of a project.
C) Synergy occurs when a new product reduces the sales of a current product.
D) Costs incurred prior to deciding whether or not to produce a new product are sunk costs.
E) Incremental costs should not be included in a project’s initial cost estimate.
6) The incremental cash flows of a project are best defined as
A) the cash received from the additional sales generated by the project.
B) any change in a firm’s cash flows resulting from the addition of the project including
opportunity costs.
C) the cash received or lost from changes in the sales of a firm’s current products as a result of
adding the project.
D) the increase or decrease in a firm’s cash flows resulting from adding the project, excluding all
sunk and opportunity costs.
E) the total cash flows of a firm once the new project is completely integrated into the firm’s
operations.
7) Which one of the following is an example of an incremental cash flow for Project A?
A) Insurance on a building the company currently owns that will house the operations for Project
A
B) Property taxes on a currently owned warehouse that has been sitting idle but is going to be
utilized by Project A
C) Cost of the test marketing to ascertain whether or not Project A is feasible
D) Rental cost of some new machinery that will be acquired for Project A
E) Contractual annual salary of the company president
8) Project analysis is focused on ________ costs.
A) total
B) sunk
C) variable
D) incremental
E) fixed
9) Sunk costs include any cost that
A) will change if a project is undertaken.
B) will be incurred if a project is accepted.
C) has previously been incurred and cannot be changed.
D) will occur if a project is accepted and once incurred, cannot be recouped.
E) is paid to a third party and cannot be refunded for any reason whatsoever.
10) You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up,
and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing
the brake situation, the $500 you spent fixing the transmission is a(n) ________ cost.
A) opportunity
B) sunk
C) incremental
D) fixed
E) relevant
11) Erosion can be best explained as the
A) loss of current sales due to a new project being implemented.
B) additional income generated from the sales of a newly added product.
C) loss of revenue due to customer theft.
D) loss of revenue due to employee theft.
E) loss of sales due to a product become obsolete.
12) Capital budgeting analysis is based on
A) the discounted cash flows incremental to a project.
B) the additional income generated from the sales of a newly added project.
C) the expected profits generated by a project’s sales and costs.
D) all incremental and allocated costs assigned to a project.
E) all past and future expenditures related to a proposed project.
13) Which of the following should be included in the analysis of a proposed project?
A) Incremental and sunk costs only
B) Opportunity costs, erosion, and sunk costs
C) Opportunity costs and synergy only
D) Synergy, erosion, opportunity costs, and incremental costs
E) Incremental costs minus any sunk costs plus synergy
14) The cash flows of a project include the
A) net operating cash flow generated by the project, less both sunk and erosion costs.
B) incremental operating cash flow, as well as any changes in capital spending and net working
capital.
C) net income generated by the project plus the annual depreciation expense.
D) sunk costs, opportunity costs, and erosion costs of the project.
E) incremental operating cash flow plus any after-tax salvage value minus opportunity costs.
15) Assume an asset costs $38,700 and has a current book value of $18,209. The asset is sold today
for $15,000 cash. The tax rate is 34 percent. As a result of this sale, the company’s net cash flow
will
A) increase by exactly $15,000.
B) decrease by the difference between the $18,209 and the $15,000.
C) increase by more than $15.000.
D) increase by less than $15,000.
E) decrease by some amount.
16) Which one of these statements related to MACRS depreciation is correct?
A) The MACRS percentages in the IRS tables are applied annually to the then current book value
of an asset.
B) The MACRS system of depreciation was eliminated by the IRS in 2012.
C) An asset will be depreciated faster using MACRS rather than the straight-line method.
D) An asset classified as 3-year MACRS property will be fully depreciated at the end of Year 3.
E) All newly acquired property is considered to be placed in service at the start of the year for
MACRS purposes.
17) In project analysis, which one of these is a common assumption regarding net working capital?
A) Only changes in current assets are included in net working capital for project analysis purposes.
B) The aftertax salvage value of an asset that is sold is included as a net working capital item.
C) Net working capital will be returned to its preproject level at the end of a project.
D) Increases in net working capital will be treated as a cash inflow.
E) Any change in net working capital will only occur when a project commences.
18) Which one of these statements related to depreciation is correct for a firm with taxable income
of $121,600 and after-tax income of $74,200?
A) Depreciation increases the net book value of the firm’s assets.
B) Depreciation is a noncash expense that increases the firm’s cash flows.
C) Depreciation lowers the firm’s net income but does not affect its cash flows.
D) Depreciation has no effect on either the firm’s net income or its cash flows.
E) Depreciation decreases both the firm’s net income and its cash flows.
19) Changes in net working capital
A) are included in project analysis only if they represent cash outflows.
B) only affect the initial cash flows of a project.
C) can affect the cash flows of a project every year of the project’s life.
D) are generally excluded from project analysis due to their irrelevance to the total project.
E) affect the initial and the final cash flows of a project but not the cash flows of the middle years.
20) Which one of the following will decrease a firm’s net working capital?
A) A decrease in fixed assets
B) An increase in inventory
C) An increase in the firm’s checking account balance
D) A decrease in accounts payable
E) A decrease in accounts receivable
21) Net working capital
A) can be ignored in project analysis because any expenditure is normally recouped by the end of
the project.
B) requirements generally, but not always, create a cash outflow at the beginning of a project.
C) expenditures commonly occur at the end of a project.
D) is ignored in project analysis because any change in net working capital is a sunk cost.
E) is the only initial expenditure where at least a partial recovery can be made at the end of a
project.
22) A company that uses the MACRS system of depreciation
A) cannot expense any of the cost of a new asset during the first year of the asset’s life.
B) will expense the entire cost of an asset over the asset’s class life.
C) will fully depreciate most assets over a 3-year period.
D) will forgo any benefits normally derived from the depreciation tax shield.
E) will have equal depreciation costs each year of an asset’s life.
23) The book value of an asset is primarily used to compute the
A) annual depreciation tax shield.
B) amount of tax due on the sale of that asset.
C) amount of tax saved annually due to the depreciation expense.
D) amount of cash that can be received from the sale of that asset.
E) change in depreciation needed to reflect the market value of the asset.
24) When compiling the relevant cash flows for a project, the after-tax value of any asset sold any
time during the life of the project should be treated as a
A) cash outflow at Time 0.
B) change in net working capital.
C) reduction in the cash flow for Time 0.
D) cash flow in the last year of the project.
E) cash flow in the year of sale.
25) The sale of an asset creates an aftertax cash flow in an amount equal to the
A) Sale price – Book value.
B) Sale price – Tax rate × (Book value – Sale price).
C) Sale price – Tax rate × (Sale price – Book value).
D) Sale price + Tax rate × (Sale price – Book value).
E) Sale price × (1 – Tax rate).
26) The pretax salvage value of an asset is equal to the
A) book value if straight-line depreciation is used.
B) book value if MACRS depreciation is used.
C) market value minus the book value.
D) book value minus the market value.
E) market value.
27) Computers used for business purposes are assigned to which MACRS property class?
A) 3-year
B) 7-year
C) 10-year
D) 5-year
E) 15-year
28) Which one of these represents the difference between a nominal rate and a real rate as they
relate to project analysis?
A) Interest rate on any project debt
B) Risk-free rate of interest
C) Market rate of return
D) Rate of inflation
E) Required rate of return
29) Which one of these is a requirement when computing the net present value of a capital project?
A) The discount rate used must be a nominal rate.
B) The discount rate must be stated in real terms.
C) Nominal cash flows must be discounted using a real rate.
D) Real cash flows must be converted to nominal cash flows.
E) Real cash flows must be discounted using a real rate.
30) Assume you computed the NPV of a project using nominal values. Your partner computed the
NPV of the identical project using real values, given a positive rate of inflation. When you
compare your results, you should discover that
A) the discount rate used by your partner is higher than the rate you used.
B) both computations used the identical discount rate.
C) your NPV value is greater than your partner’s NPV value.
D) your partner’s initial cash flow at Time 0 is less than the value you used for Time 0.
E) your NPV values are identical.
31) All else equal, a project’s operating cash flow will increase when the
A) net working capital requirement increases.
B) sales projections are lowered.
C) interest expense is lowered.
D) depreciation expense increases.
E) earnings before interest and taxes decreases.
32) Which of the following are correct methods of computing the operating cash flow of a project
assuming that the interest expense is equal to zero?
I. EBIT + Depreciation − Taxes
II. EBIT − Depreciation + Taxes
III. Net Income − Depreciation
IV. [(Sales − Costs) × (1 − Tax rate)] + [Depreciation × Tax rate]
A) I and III only
B) II and IV only
C) II and III only
D) I and IV only
E) I, III, and IV only
33) The bottom-up approach to computing the operating cash flow of a project applies only when
A) both the depreciation expense and the interest expense are equal to zero.
B) the project is a cost-cutting project.
C) the interest expense is equal to zero.
D) no fixed assets are required for the project.
E) taxes are ignored and the interest expense is equal to zero.
34) The top-down approach to computing the operating cash flow
A) applies only if a project produces sales.
B) ignores all noncash items.
C) can only be used if the entire cash flows of a firm are included.
D) is equal to (Sales − Costs − Taxes + Depreciation).
E) includes the interest expense related to a project.
35) All else equal, an increase in which one of the following will increase the operating cash flow?
A) Employee salaries
B) Office rent
C) Building maintenance
D) Equipment rental
E) Equipment depreciation
36) A new machine, with a 4-year life, has an initial cost of $1,200 and annual costs of $380. The
equivalent annual cost of this machine is best described as the
A) 4-year annuity payment that has the same net present value as the project’s costs given a stated
discount rate.
B) 4-year total of all costs divided by four.
C) annual sales needed to offset these additional costs.
D) lump sum payment at Time 0 that is equal to these additional costs at a given discount rate.
E) 4-year average after-tax cash flow resulting from the annual costs.
37) Assume a firm has an ongoing need for a machine, and the current machine is operating
efficiently. The firm should plan to replace this machine when it
A) reaches the end of its depreciable life.
B) is fully paid for.
C) reaches a point where the book value is less than half of the original cost.
D) can be replaced with a machine that has a lower equivalent annual cost.
E) can be sold at a price that exceeds the current book value.
38) The equivalent annual cost is a method used to primarily compare mutually exclusive
machines
A) with different initial costs but similar lives.
B) depreciated using various methods.
C) that will be replaced with those that will not.
D) that perform different functions.
E) that will be replaced and have unequal lives.
39) Toni’s Tools is comparing machines to determine which one to purchase. The machines sell for
differing prices, have differing operating costs, differing machine lives, and will be replaced when
worn out. These machines should be compared using
A) net present value only.
B) both net present value and the internal rate of return.
C) the replacement parts approach.
D) the depreciation tax shield approach.
E) the equivalent annual cost method.
40) When determining a minimum bid price, you should assume the
A) net present value is zero.
B) net profit is zero.
C) discount rate equals the risk-free rate.
D) depreciation is based on the straight-line method.
E) fixed assets are unaffected.
41) Uptown Furniture purchased a corner lot 5 years ago at a cost of $670,000. The lot was
recently appraised at $640,000. At the time of the purchase, the company spent $45,000 to grade
the lot and another $100,000 to pave the lot for commuter parking. The company now wants to
build a new retail store on the site. The building cost is estimated at $1.6 million. What amount
should be used as the initial cash flow for this building project?
A) $2,415,000
B) $1,600,000
C) $2,385,000
D) $2,240,000
E) $2,270,000
42) Riverton Sails is considering expanding its sail production operations to include awnings. The
expansion would use land currently valued at $898,000 that was purchased for $779,000 cash. The
expansion would require modifications costing $18,400 to some unused equipment along with the
purchase of $314,800 of new equipment.The unused equipment is debt-free, fully depreciated, and
has a market value of $27,900. What is the Time 0 cash flow for this expansion project?
A) $1,231,200
B) $1,139,900
C) $333,200
D) $452,200
E) $1,259,100
43) Aaron’s Paint paid $412,000, in cash, for a piece of equipment 3 years ago. Last year, the
company spent $28,000 on equipment upgrades. The equipment is being depreciated using the
straight-line method over seven years. The company no longer uses this equipment in its current
operations and has received an offer of $164,000 from a firm that would like to purchase it. If the
company should decide to use this equipment in an upcoming project, what cost, if any, should be
assigned to the project for this equipment?
A) $0
B) $192,000
C) $164,000
D) $259,429
E) $423,429
44) Julian’s has spent $47,200 to design a new airline carryon bag. It spent another $56,500 testing
various materials for their durability. An additional $75,000 was spent on test marketing to
determine both the market demand and color preference. Since the test marketing proved
successful, the firm is now compiling data to evaluate the addition of this bag to its production
runs. The estimated production start up costs are $932,300 with annual costs thereafter of $57,000.
The discount rate is 11 percent and the estimated life of the project is 5 years. What value should be
used for the Time 0 cash flow?
A) −$932,300
B) −$1,217,300
C) −$654,973
D) −$1,036,000
E) −$1,111,000
45) Hill Motor Homes currently sells 1,160 Class A motor homes, 2,170 Class C motor homes, and
1,600 pop-up trailers each year. It is considering adding a midrange camper and expects that if it
does so the firm can sell 800 of them. However, if the new camper is added, the firm expects its
Class A sales to decline by 8 percent while the Class C camper sales decline to 1,950 units. The
sales of pop-ups will not be affected. Class A motor homes sell for an average of $179,000 each.
Class C homes are priced at $64,500, and the pop-ups sell for $5,700 each. The new midrange
camper will sell for $26,900. What is the erosion cost of the new camper?
A) $38,323,800
B) $30,801,200
C) $49,350,000
D) $1,478,800
E) $2,118,600
46) Global Enterprises is considering a new 5-year project that will require $872,000 for new fixed
assets, $210,000 for inventory, and $80,000 for accounts receivable. Short-term debt is expected to
increase by $140,000. The fixed assets will be depreciated straight-line to zero over the project’s
life. At the end of the project, the fixed assets are expected to be sold for 30 percent of their original
cost, and the net working capital will return to its original level.The tax rate is 35 percent. What is
the initial cost of this project?
A) $446,040
B) $1,022,000
C) $726,040
D) $1,302,000
E) $170,040
47) Farris Industrial purchased a machine 5 years ago at a cost of $229,380. The machine is being
depreciated using the straight-line method over 8 years. The tax rate is 35 percent and the discount
rate is 16 percent. If the machine is sold today for $74,500, what will be the after-tax salvage
value?
A) $74,500.00
B) $67,625.09
C) $78,531.13
D) $37,389.69
E) $115,454.05
48) Walks Softly sells customized shoes. Currently, it sells 14,800 pairs of shoes annually at an
average price of $79 a pair. The company is considering adding a lower-priced line of shoes that
will sell for $59 a pair. The company estimates it can sell 4,800 pairs of the lower-priced shoes but
will sell 1,900 less pairs of the higher-priced shoes by doing so. What is the amount of the sales
that should be used when evaluating the addition of the lower-priced shoes?
A) $133,100
B) $1,245,000
C) $416,300
D) $1,302,300
E) $283,200
49) Sun Lee’s Furniture just purchased $387,269 of fixed assets classified as 5-year property for
MACRS. The MACRS table values are 0.2000, 0.3200, 0.1920, 0.1152, 0.1152, and 0.0576 for
Years 1 to 6, respectively. What is the amount of the depreciation expense for the third year?
A) $40,449.47
B) $54,019.09
C) $123,926.08
D) $102,004.20
E) $74,355.65
50) Lefty’s just purchased some equipment that is classified as 7-year property for MACRS. The
equipment cost $123,940. The MACRS table values are 0.1429, 0.2449, 0.1749, 0.1249, and
0.0893, for Years 1 to 5, respectively. What will the book value of this equipment be at the end of
4 years?
A) $38,718.86
B) $36,036.68
C) $47,040.00
D) $44,566.04
E) $48,443.24