Fundamentals of Corporate Finance, 12e (Ross)
Chapter 10 Making Capital Investment Decisions
1) The difference between a company’s future cash flows if it accepts a project and the
company’s future cash flows if it does not accept the project is referred to as the project’s:
A) incremental cash flows.
B) internal cash flows.
C) external cash flows.
D) erosion effects.
E) financing cash flows.
2) The fact that a proposed project is analyzed based on the project’s incremental cash flows is
the assumption behind which one of the following principles?
A) Underlying value principle
B) Stand-alone principle
C) Equivalent cost principle
D) Salvage principle
E) Fundamental principle
3) The stand-alone principle advocates that project analysis should be based solely on which one
of the following costs?
A) Sunk
B) Total
C) Variable
D) Incremental
E) Fixed
4) Kelley’s Baskets makes handmade baskets and is currently considering making handmade
wreaths as well. Which one of the following is the best example of an incremental operating cash
flow related to the wreath project?
A) Storing supplies in the same space currently used for materials storage
B) Utilizing the basket manager to oversee wreath production
C) Hiring additional employees to handle the increased workload should the firm accept the
wreath project
D) Researching the market to determine if wreath sales might be profitable before deciding to
proceed
E) Planning on lower interest expense by assuming the proceeds of the wreath sales will be used
to reduce the firm’s currently outstanding debt
5) Frank’s is a furniture store that is considering adding appliances to its offerings. Which one of
the following is the best example of an incremental cash flow related to the appliances?
A) Moving furniture to provide floor space for the appliances
B) Paying the rent for the store
C) Selling furniture to appliance customers
D) Having the current store manager oversee appliance sales
E) Using the store’s billing system for appliance sales
6) Which one of the following costs was incurred in the past and cannot be recouped?
A) Incremental
B) Side
C) Sunk
D) Opportunity
E) Erosion
7) The option that is forgone so that an asset can be utilized by a specific project is referred to as
which one of the following?
A) Salvage value
B) Wasted value
C) Sunk cost
D) Opportunity cost
E) Erosion
8) Which one of the following is an example of a sunk cost?
A) $1,500 of lost sales because an item was out of stock
B) $1,200 paid to repair a machine last year
C) $20,000 project that must be forfeited if another project is accepted
D) $4,500 reduction in current shoe sales if a store commences selling sandals
E) $1,800 increase in comic book sales if a store ceases selling puzzles
9) GL Plastics spent $1,200 last week repairing a machine. This week the company is trying to
decide if the machine could be better utilized if they assigned it a proposed project. When
analyzing the proposed project, the $1,200 should be treated as which type of cost?
A) Opportunity
B) Fixed
C) Incremental
D) Erosion
E) Sunk
10) Which one of the following best illustrates erosion as it relates to a hot dog stand located on
the beach?
A) Providing both ketchup and mustard for customers’ use
B) Repairing the roof of the hot dog stand because of water damage
C) Selling fewer hot dogs because hamburgers were added to the menu
D) Offering french fries but not onion rings
E) Losing sales due to bad weather
11) Which one of the following should not be included in the analysis of a new product?
A) Increase in accounts payable for inventory purchases of the new product
B) Reduction in sales for a current product once the new product is introduced
C) Market value of a machine owned by the firm which will be used to produce the new product
D) Money already spent for research and development of the new product
E) Increase in accounts receivable needed to finance sales of the new product
12) Which one of the following best describes the concept of erosion?
A) Expenses that have already been incurred and cannot be recovered
B) Change in net working capital related to implementing a new project
C) The cash flows of a new project that come at the expense of a firm’s existing cash flows
D) The alternative that is forfeited when a fixed asset is utilized by a project
E) The differences in a firm’s cash flows with and without a particular project
13) Pro forma financial statements can best be described as financial statements:
A) expressed in a foreign currency.
B) where the assets are expressed as a percentage of total assets and costs are expressed as a
percentage of sales.
C) showing projected values for future time periods.
D) expressed in real dollars, given a stated base year.
E) where all accounts are expressed as a percentage of last year’s values.
14) Pro forma statements for a proposed project should generally do all of the following except:
A) be compiled on a stand-alone basis.
B) include all project-related fixed asset acquisitions and disposals.
C) include all the incremental cash flows related to the project.
D) include taxes.
E) include interest expense.
15) A project’s cash flow is equal to the project’s operating cash flow:
A) plus the project’s depreciation expense minus both the project’s taxes and capital spending.
B) minus both the project’s change in net working capital and capital spending.
C) minus the project’s change in net working capital plus all of the depreciation expenses.
D) plus the project’s depreciation expenses minus the project’s taxes.
E) minus the project’s taxes.
16) Which one of the following is a project cash inflow? Ignore any tax effects.
A) Decrease in accounts payable
B) Increase in accounts receivable
C) Decrease in inventory
D) Depreciation expense
E) Equipment acquisition
17) Net working capital:
A) can be ignored in project analysis because any expenditure is normally recouped at the end of
the project.
B) requirements, such as an increase in accounts receivable, create a cash inflow at the beginning
of a project.
C) is rarely affected when a new product is introduced.
D) can create either an initial cash inflow or outflow.
E) is the only expenditure where at least a partial recovery can be made at the end of a project.
18) All of the following are related to a proposed project. Which one of these should be included
in the cash flow at Time 0?
A) Loan obtained to finance the project
B) Initial investment in inventory to support the project
C) Annual depreciation tax shield
D) Aftertax salvage value
E) Net working capital recovery
19) Changes in the net working capital requirements:
A) can affect the cash flows of a project every year of the project’s life.
B) only affect the initial cash flows of a project.
C) only affect the initial and final cash flows of a project.
D) are generally excluded from project analysis due to their irrelevance to the total project.
E) are excluded from project analysis as long as they are recovered when the project ends.
20) Dependable Motors just purchased some MACRS five-year property at a cost of $216,000.
The MACRS rates are .2, .32, and .192 for Years 1 to 3, respectively. Assume the firm opted to
forego any bonus depreciation. Which one of the following will correctly give you the book
value of this equipment at the end of Year 2?
A) $216,000/(1 + .2 + .32)
B) $216,000(1 − .2 − .32)
C) $216,000(.20 + .32)
D) [$216,000(1 − .20)](1 − .32)
E) $216,000[(1 + .20)(1 + .32)]
21) P.A. Petroleum just purchased some equipment at a cost of $67,000. The equipment is
classified as MACRS five-year property. The MACRS rates are .2, .32, and .192 for Years 1 to 3,
respectively. What is the proper methodology for computing the depreciation expense for Year 2
assuming the firm opts to forego any bonus depreciation?
A) $67,000(1 − .20)(.32)
B) $67,000/(1 − .20 − .32)
C) $67,000(1.32)
D) $67,000(1 − .32)
E) $67,000(.32)
22) The current book value of a fixed asset that was purchased two years ago is used in the
computation of which one of the following?
A) Depreciation tax shield
B) Tax due on the current salvage value of that asset
C) Current year’s operating cash flow
D) Change in net working capital
E) MACRS depreciation for the current year
23) Ignoring bonus depreciation, the net book value of equipment will:
A) remain constant over the life of the equipment.
B) vary in response to changes in the market value of that equipment.
C) decrease at a constant rate when MACRS depreciation is used.
D) increase over the taxable life of an asset.
E) decrease slower under straight-line depreciation than under MACRS.
24) Three years ago, Knox Glass purchased a machine for a three-year project. The machine is
being depreciated straight-line to zero over a five-year period. Assume the firm decided to forego
any bonus depreciation. Today, the project ended and the machine was sold. Which one of the
following correctly defines the aftertax salvage value of that machine? (TC represents the
relevant tax rate)
A) Sale price + (Sale price − Book value)(TC)
B) Sale price + (Sale price − Book value)(1 − TC)
C) Sale price + (Book value − Sale price)(TC)
D) Sale price + (Book value − Sale price)(1 − TC)
E) Sale price(1 − TC)
25) Atlas Manufacturing purchased a new computer system in 2018 at a cost of $622,400. This
system falls in the 5-year MACRS class that has depreciation allowance percentages of 20, 32,
19.2, 11.52, 11.52, and 5.76. What is the maximum amount of depreciation the firm can claim on
this system in the first year if it selects the bonus depreciation method?
A) $311,200
B) $124,480
C) $199,168
D) $622,400
E) $155,600
26) A company that utilizes the MACRS system of depreciation but does not use bonus
depreciation:
A) will have equal depreciation costs each year of an asset’s life.
B) will have a greater depreciation tax shield in Year 2 than in Year 1.
C) can depreciate the cost of land.
D) will expense less than the entire cost of an asset.
E) will fully depreciate a MACRS five-year asset within 5 years.
27) Which one of the following is a correct method for computing the operating cash flow of a
project assuming that the interest expense is equal to zero?
A) EBIT + Depreciation
B) EBIT(1 + Taxes)
C) Net income + Depreciation
D) (Sales − Costs)(1 − Depreciation)(1 − Taxes)
E) (Sales − Costs)(1 − Taxes)
28) The operating cash flow for a project should exclude which one of the following?
A) Taxes
B) Variable costs
C) Fixed costs
D) Interest expense
E) Depreciation tax shield
29) The bottom-up approach to computing the operating cash flow applies only when:
A) both the depreciation expense and the interest expense are equal to zero.
B) the interest expense is equal to zero.
C) the project is a cost-cutting project.
D) no fixed assets are required for a project.
E) both taxes and the interest expense are equal to zero.
30) The top-down approach to computing the operating cash flow:
A) ignores noncash expenses.
B) applies only if a project affects sales.
C) applies only to cost cutting projects.
D) is equal to sales − costs − taxes + depreciation.
E) is used solely to compute a bid price.
31) Increasing which one of the following will increase the operating cash flow of a profitable,
tax paying company assuming that the bottom-up approach is used to compute the operating cash
flow?
A) Erosion effects
B) Taxes
C) Fixed expenses
D) Salaries
E) Depreciation expense
32) The depreciation tax shield is best defined as the:
A) amount of tax that is saved when an asset is purchased.
B) tax that is avoided when an asset is sold as salvage.
C) amount of tax that is due when an asset is sold.
D) amount of tax that is saved because of the depreciation expense.
E) amount by which the aftertax depreciation expense lowers net income.
33) Dexter Smith & Co. is replacing a machine simply because it has worn out. The new
machine will not affect either sales or operating costs and will not have any salvage value at the
end of its five-year life. The firm has a tax rate of 22 percent, uses straight-line depreciation over
an asset’s life, ignores bonus depreciation options, and has a positive net income. Given this,
which one of the following statements is correct?
A) As a project, the new machine has a net present value equal to minus one times the machine’s
purchase price.
B) The new machine will have a zero rate of return.
C) The new machine will generate positive operating cash flows.
D) The new machine will create a cash outflow when the firm disposes of the machine at the end
of its life.
E) The new machine creates erosion effects.
34) The annual annuity stream of payments that has the same present value as a project’s costs is
referred to as which one of the following?
A) Yearly incremental costs
B) Sunk costs
C) Opportunity costs
D) Annuitized erosion cost
E) Equivalent annual cost
35) You are considering the purchase of a new machine. Your analysis includes the evaluation of
two machines that have differing initial and ongoing costs and differing lives. Whichever
machine is purchased will be replaced at the end of its useful life. You should select the machine
that has the:
A) longest life.
B) highest annual operating cost.
C) lowest annual operating cost.
D) highest equivalent annual cost.
E) lowest equivalent annual cost.
36) The bid price is the:
A) price you must charge to break even at a zero discount rate.
B) the aftertax contribution margin.
C) the highest price you should charge if you want to win the bid.
D) the only price you can bid if the project is to be profitable.
E) the minimum price that will provide your target rate of return.
37) Which one of the following will increase a bid price?
A) A decrease in the fixed costs
B) A reduction in the net working capital requirement
C) A reduction in the firm’s tax rate
D) An increase in the salvage value
E) An increase in the required rate of return
38) The operating cash flow of a cost-cutting project:
A) is equal to the depreciation tax shield.
B) is equal to zero because there is no incremental sales.
C) can only be analyzed by projecting the sales and costs for a firm’s entire operations.
D) includes any changes that occur in the current accounts.
E) can be positive even though there are no sales.
39) Which one of the following statements is correct?
A) Project analysis should only include the cash flows that affect the income statement.
B) A project can create a positive operating cash flow without affecting sales.
C) The depreciation tax shield creates a cash outflow for a project.
D) Interest expense should always be included when analyzing cost-cutting projects.
E) A bid price maximizes profits on a project for the bidding firm.
40) Which one of the following statements is correct concerning bid prices?
A) The bid price is the maximum price that a firm should bid.
B) A firm can submit a bid that is higher than the computed bid price and still break even.
C) A bid price ignores taxes.
D) A bid price should be computed based solely on the operating cash flows of the project.
E) A bid price should be computed based on a zero percent required rate of return.
41) Dan is comparing three machines to determine which one to purchase. The machines sell for
differing prices, have differing operating costs and machine lives, and will be replaced when
worn out. Which one of the following computational methods should Dan use as the basis for his
decision?
A) Internal rate of return
B) Net present value
C) Equivalent annual cost
D) Depreciation tax shield
E) Bottom-up operating cash flow
42) The equivalent annual cost method is useful in determining:
A) which one of two machines to purchase if the machines are mutually exclusive, have differing
lives, and are a one-time purchase.
B) the operating cash flow for mutually exclusive projects ignoring any fixed asset acquisitions
or dispositions.
C) the minimum price that should be bid to earn a specified rate of return.
D) which one of two investments to accept when the investments have differing required rates of
return, differing costs, and will not be replaced once they wear out.
E) which one of two machines should be purchased when the machines are mutually exclusive,
have differing lives, and will be replaced at the end of their lives.
43) Assume you are considering two mutually exclusive machines and need to select one for a
cost-cutting project. Which one of these sets of characteristics best indicates the use of the
equivalent annual cost method of analysis?
A) Differing costs with no replacement at end of life
B) Differing lives and planned replacement at end of life
C) Differing lives with no replacement at end of life
D) Differing manufacturers and differing operating costs
E) Differing required returns with no replacement at end of life
44) The equivalent annual cost considers all of the following except the:
A) required rate of return.
B) operating costs.
C) need for replacement.
D) economic life.
E) costs of research conducted to identify equipment choices.
45) The bid price always assumes which one of the following?
A) A project has a one-year life.
B) The aftertax net income of the project is zero.
C) The net present value of the project is zero.
D) Any assets purchased will have a positive salvage value at the end of the project.
E) Assets will be depreciated based on MACRS.
46) Which one of the following would make a mutually exclusive project unacceptable?
A) Cash inflow for net working capital at Time 0
B) Requiring fixed assets that would have no salvage value
C) An equivalent annual cost that exceeds that of an alternative project
D) Lack of revenue generation
E) A depreciation tax shield that exceeds the value of the interest expense
47) Decreasing which one of the following will increase the acceptability of a project?
A) Sunk costs
B) Salvage value
C) Depreciation tax shield
D) Equivalent annual cost
E) Accounts payable requirement