CHAPTER8:CAPITALBUDGETINGDECISIONSPARTII

MultipleChoice

c1.Whichofthefollowinggroupsofcapitalbudgetingtechniquesusesthetimevalueofmoney?
a.Bookrateofreturn,payback,andprofitabilityindex.
b.IRR,payback,andNPV.
c.IRR,NPV,andprofitabilityindex.
d.IRR,bookrateofreturn,andprofitabilityindex.

b2.DiscountedcashflowtechniquesforanalyzingcapitalbudgetingdecisionsareNOTnormallyappliedto
projects
a.requiringnoinvestmentafterthefirstyearoflife.
b.havingusefullivesshorterthanoneyear.
c.thatareessentialtothebusiness.
d.involvingreplacementofexistingassets.

d3.Theprofitabilityindex
a.doesnotusepresentvaluesofcashflows.
b.isgenerallypreferabletoanyotherapproachforevaluatingmutuallyexclusiveinvestment
alternatives.
c.producesthesamerankingofinvestmentalternativesasdoestheIRRcriterion.
d.isadiscountedcashflowmethod.

a4.CompaniesusingMACRSfortaxpurposesandstraightlinedepreciationforfinancialreportingpurposes
usuallyfindthattherelationshipbetweenthetaxbasisandbookvalueoftheirassetsis
a.thetaxbasisislowerthanbookvalue.
b.thetaxbasisishigherthanbookvalue.
c.thetaxbasisisthesameasbookvalue.
d.noneoftheabove.

c5.AcompanythatwantstouseMACRSfortaxpurposesmust
a.requestpermissionfromtheIRS.
b.acquirenewassetsatornearthemiddleoftheyear.
c.ignoresalvagevalueincalculatingdepreciation.
d.dononeoftheabove.

c6.Thegovernmentcouldencourageincreasesininvestmentby
a.increasingtaxrates.
b.lengtheningtheMACRSperiods.
c.lettingacompanyexpensefixedassetsintheyearacquiredinsteadofthroughannualdepreciation
charges.
d.takingactionsthatwouldincreaseinterestrates.

a7.Inchoosingfromamongmutuallyexclusiveinvestmentsthemanagershouldnormallyselecttheonewiththe
highest
a.NPV.
b.IRR.
c.profitabilityindex.
d.bookrateofreturn.

a8.Indecidingwhethertoreplaceamachine,whichofthefollowingisNOTasunkcost?
a.Theexpectedresalepriceoftheexistingmachine.
b.Thebookvalueoftheexistingmachine.
c.Theoriginalcostoftheexistingmachine.
d.Thedepreciatedcostoftheexistingmachine.

a9.Acompanyisconsideringreplacingamachinewithonethatwillsave$50,000peryearincashoperating
costsandhave$20,000moredepreciationexpenseperyearthantheexistingmachine.Thetaxrateis40%.
Buyingthenewmachinewillincreaseannualnetcashflowsofthecompanyby
a.$38,000.
b.$30,000.
c.$20,000.
d.$12,000.

c10.Notforprofitentities
a.cannotusecapitalbudgetingtechniquesbecauseprofitabilityisirrelevanttothem.
b.cannotusediscountedcashflowtechniquesbecausethetimevalueofmoneyisirrelevanttothem.
c.mighthaveseriousproblemsinquantifyingthebenefitsexpectedfromaninvestment.
d.shouldusetheIRRmethodtomakeinvestmentdecisions.

c11.Amajordifferencebetweenaninvestmentinworkingcapitalandoneindepreciableassetsisthat
a. aninvestmentinworkingcapitalisneverreturned,whilemostdepreciableassetshavesomeresidual
value.
b.aninvestmentinworkingcapitalisreturnedinfullattheendofaproject'slife,whilean
investmentindepreciableassetshasnoresidualvalue.
c.aninvestmentinworkingcapitalisnottaxdeductiblewhenmade,nortaxablewhenreturned,whilean
investmentindepreciableassetsdoesallowtaxdeductions.
d.becauseaninvestmentinworkingcapitalisusuallyreturnedinfullattheendoftheproject'slife,
itisignoredincomputingtheamountoftheinvestmentrequiredfortheproject.

d12.Thepropertreatmentofaninvestmentinreceivablesandinventoryisto
a.ignoreit.
b.addittotherequiredinvestmentinfixedassets.
c.addittotherequiredinvestmentinfixedassetsandsubtractitfromtheannualcashflows.
d.addittotheinvestmentinfixedassetsandaddthepresentvalueoftherecoverytothepresentvalue
oftheannualcashflows.
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a13.IfacompanyusesafiveyearMACRSperiodtodepreciateassetsinsteadofa10yearlifewithstraight
linedepreciation,
a.theNPVoftheinvestmentishigher.
b.theIRRoftheinvestmentislower.
c.thereisnodifferenceineitherNPVorIRR.
d.totalcashflowsovertheusefullifewouldbelower.

a14.TheNPVandIRRmethodsgive
a.thesamedecision(acceptorreject)foranysingleinvestment.
b.thesamechoicefromamongmutuallyexclusiveinvestments.
c.differentrankingsofprojectswithunequallives.
d.thesamerankingsofprojectswithdifferentrequiredinvestments.

d15.AninvestmentwithapositiveNPValsohas
a.apositiveprofitabilityindex.
b.aprofitabilityindexofone.
c.aprofitabilityindexlessthanone.
d.aprofitabilityindexgreaterthanone.

b16.ClassifyinganassetinaMACRSlifecategoryisbasedon
a.usefullifeestimatedbythecompany.
b.assetdepreciationrange(ADR)guidelines.
c.thecostoftheasset.
d.anyoftheabovefactors.

d17.Whichofthefollowingmakesinvestmentsmoredesirablethantheyhadbeen?
a.Anincreaseintheincometaxrate.
b.Anincreaseininterestrates.
c.Anincreaseinthenumberofyearsoverwhichassetsmustbedepreciated.
d.Noneoftheabove.

c18.Whichofthefollowingstatementsistrue?
a.Allrevenueistaxed.
b.Allexpensesaretaxdeductible.
c.Somerevenuesandexpenseshavenotaxeffects.
d.Incometaxesarebasedsolelyonrevenuesandexpenses.

b19.Theprofitabilityindexistheratioof
a.totalcashinflowstothecostoftheinvestment.
b.thepresentvalueofcashinflowstothecostoftheinvestment.
c.theNPVoftheinvestmenttothecostoftheinvestment.
d.theIRRtothecompany'scostofcapital.

c20.Withrespecttoincometaxes,theprincipaladvantageofMACRSoverstraightlinedepreciationisthat
a.totaltaxeswillbelowerunderMACRS.
b.taxeswillbeconstantfromyeartoyearunderMACRS.
c.taxeswillbelowerintheearlieryearsunderMACRS.
d.taxeswilldeclineinfutureyearsunderMACRS.

a21.Iftheprofitabilityindexislessthanone,
a.theIRRislessthancostofcapital.
b.theIRRisthesameascostofcapital.
c.theIRRisgreaterthancostofcapital.
d.noneoftheaboveistrue.

c22.Whichofthefollowingcombinationsispossible?
ProfitabilityIndexNPVIRR

a.greaterthan1positiveequalscostofcapital
b.greaterthan1negativelessthancostofcapital
c.lessthan1negativelessthancostofcapital
d.lessthan1positivelessthancostofcapital
d23.WhichofthefollowingcombinationsisNOTpossible?
ProfitabilityIndexNPVIRR

a.greaterthan1positivemorethancostofcapital
b.equals1zeroequalscostofcapital
c.lessthan1negativelessthancostofcapital
d.lessthan1positivelessthancostofcapital

b24.Incapitalbudgeting,sensitivityanalysisisused
a.todeterminewhetheraninvestmentisprofitable.
b.toseehowadecisionwouldbeaffectedbychangesinvariables.
c.totesttherelationshipoftheIRRandNPV.
d.toevaluatemutuallyexclusiveinvestments.

b25.Auniquefeatureoftheanalysisofareplacementdecisionisthat
a.theanalysisconsiderstotalratherthandifferentialcosts.
b.theamountusedasthecostoftheinvestmentisnotlikelytoequalthepricetobepaidforthenew
asset.
c.thetimevalueofmoneyisignored.
d.suchdecisionsseldominvolvecashflows.

a26.Becauseofidlecapacity,acompanyisconsideringtwoassetsforsale.Theyareidenticalinall
respectsexceptthatassetAhasahighertaxbasisthanassetB.Onlyoneneedbesoldnowandthe
marketpriceisthesameforbothassets.Whichofthefollowingistrue?
a.ThecashflowisgreaterfromsellingassetA.
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b.ThecashflowisgreaterfromsellingassetB.
c.Thecashflowisthesamenomatterwhichoneissold.
d.Itisnotpossibletodeterminehowthecashflowsfromsalesoftheassetswilldiffer.

a27.Ifthetaxlawwerechangedsothatownersofapartmentbuildingshadtodepreciatethemover50years
insteadofthecurrent31.5years,
a.rentswouldrise.
b.rentswouldfallbecauseannualdepreciationchargeswouldfall.
c.rentswouldstayaboutthesame.
d.morepeoplewouldinvestinapartmentbuildings.

b28.Whichstatementcouldexpresstheresultsofasensitivityanalysisofaninvestmentdecision?
a.TheNPVoftheprojectis$50,000.
b.A5%declineinvolumewillmaketheprojectunprofitable.
c.Thisprojectranksthirdoutofthefiveavailable.
d.Thisprojectdoesnotmeetthecutoffrateofreturn.

c29.XYZCo.isadoptingjustintimeprinciples.Whenevaluatinganinvestmentprojectthatwouldreduce
inventory,howshouldXYZtreatthereduction?
a.Ignoreit.
b.Decreasethecostoftheinvestmentanddecreasecashflowsattheendoftheproject'slife.
c.Decreasethecostoftheinvestment.
d.Decreasethecostoftheinvestmentandincreasethecashflowattheendoftheproject'slife.

b30.Whichofthefollowingcombinationsofcapitalbudgetingtechniquesincludesonlydiscountedcashflow
techniques?
a.Bookrateofreturn,payback,andprofitabilityindex.
b.NPV,IRR,andprofitabilityindex.
c.IRR,payback,andNPV.
d.Profitabilityindex,NPV,andpayback.

d31.Aninvestmentwhoseprofitabilityindexis1.00
a.hasanIRRequaltotheprevailinginterestrate.
b.returnstothecompanyonlythecashoutlayfortheinvestment.
c.hasapaybackperiodequaltoitsusefullife.
d.hasanNPVofzero.

a32.Inconnectionwithacapitalbudgetingproject,aninvestmentinworkingcapitalisnormallyrecovered
a.attheendoftheproject'slife.
b.inthefirstyearoftheproject'slife.
c.evenlythroughtheproject'slife.
d.whenthecompanygoesoutofbusiness.

b33.Forinvestmentsthathaveonlycosts(norevenuesorcostsavings),anappropriatedecisionruleisto
accepttheprojectthathasthe
a.longestpaybackperiod.
b.lowestpresentvalueofcashoutflows.
c.higherpresentvalueoffuturecashoutflows.
d.lowestinternalrateofreturn.

b34.Thecashinflowfromthereturnofaninvestmentinworkingcapitalis
a.adjustedfortaxesdue.
b.discountedtopresentvalue.
c.ignoredifanydepreciableassetsalsoinvolvedintheprojecthavenoexpectedresidualvalue.
d.notreal.

d35.NPVisappropriatetousetoanalyzewhichdecisionrelatingtoajointproductscompany?
a.Whetherornottosellfacilitiesnowusedforadditionalprocessingofoneofthejointproducts.
b.Whetherornottoacquirefacilitiesneededforadditionalprocessingofoneofthejointproducts.
c.Whetherornottosellfacilitiesnowusedtooperatethejointprocess.
d.Alloftheabove.

d36.IfXCo.expectstogetaoneyearbankloantohelpcovertheinitialfinancingofcapitalprojectQ,the
analysisofQshould
a.offsettheloanagainstanyinvestmentininventoryorreceivablesrequiredbytheproject.
b.showtheloanasanincreaseintheinvestment.
c.showtheloanasacashoutflowinthesecondyearoftheproject'slife.
d.ignoretheloan.

d37.AprojectthathasanegativeNPV
a.hasapaybackperiodlongerthanitslife.
b.hasanegativeprofitabilityindex.
c.mustberejected.
d.doesn'tnecessarilyfitanyoftheabovedescriptions.

c38.Acompanyevaluatesaprojectusingstraightlinedepreciationoverits10yearestimatedusefullifeand
thenreevaluatesitusinga7yearMACRSclasslife.Thesecondanalysiswillshow
a.alowerIRRfortheproject.
b.thesameNPVandIRRfortheproject.
c.ahigherNPVfortheproject.
d.lowertotalcashflowsoverthe10years.

a39.Assumingthataprojecthasalreadybeenevaluatedusingthefollowingtechniques,theevaluationunder
whichtechniqueisleastlikelytobeaffectedbyanincreaseintheestimatedresidualvalueofthe
project?
a.Paybackperiod.
b.IRR.
c.NPV.
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d.PI.

d40.Qualitativefactorscaninfluencemanagersto
a.acceptaninvestmentprojecthavingnegativeNPV.
b.rejectaninvestmentprojecthavinganIRRgreaterthanthecompany'scutoffrate.
c.raisethe"ranking"ofaninvestmentproject.
d.takeanyoftheabovecoursesofaction.

a41.Thereplacementdecisionis
a.anexampleofadecisionamongmutuallyexclusivealternatives.
b.bestarrivedatbyusingthetotalprojectratherthanthedifferentialapproach.
c.devoidofqualitativeissues.
d.noneoftheabove.

c42.Acmeisconsideringthesaleofamachinewithabookvalueof$160,000and3yearsremaininginits
usefullife.Straightlinedepreciationof$50,000annuallyisavailable.Themachinehasacurrent
marketvalueof$200,000.Whatisthecashflowfromsellingthemachineifthetaxrateis40%?
a.$50,000
b.$160,000
c.$184,000
d.$200,000

c43.Hoffisconsideringthesaleofamachinewithabookvalueof$160,000and3yearsremaininginits
usefullife.Straightlinedepreciationof$50,000annuallyisavailable.Themachinehasacurrent
marketvalueof$100,000.Whatisthecashflowfromsellingthemachineifthetaxrateis40%?
a.$50,000
b.$100,000
c.$124,000
d.$160,000

a44.AltoonaCompanyisconsideringreplacingamachinewithabookvalueof$200,000,aremainingusefullife
of4years,andannualstraightlinedepreciationof$50,000.Theexistingmachinehasacurrentmarket
valueof$175,000.Thereplacementmachinewouldcost$320,000,havea4yearlife,andsave$100,000per
yearincashoperatingcosts.Ifthereplacementmachinewouldbedepreciatedusingthestraightline
methodandthetaxrateis40%,whatwouldbetheincreaseinannualincometaxesifthecompanyreplaces
themachine?
a.$28,000
b.$40,000
c.$42,000
d.$64,000

b45. Aninvestmentopportunitycosting$300,000isexpectedtoyieldnetcashflowsof$100,000annuallyfor
fiveyears.Theprofitabilityindexoftheinvestmentatacutoffrateof14%wouldbe
a.3.0.
b.1.14.
c.0.33.
d.14%.

d46.AprojecthasaNPVof$30,000whenthecutoffrateis10%.Theannualcashflowsare$41,010onan
investmentof$100,000.Theprofitabilityindexforthisprojectis
a.1.367.
b.3.333.
c.2.438.
d.1.300.

c47.AprojecthasanIRRinexcessofthecostofcapital.Theprofitabilityindexforthisprojectwouldbe
a.lessthanzero.
b.betweenzeroandone.
c.greaterthanone.
d.cannotbedeterminedwithoutmoreinformation.

b48.AprojecthasanIRRlessthanthecostofcapital.Theprofitabilityindexforthisprojectwouldbe
a.lessthanzero.
b.betweenzeroandone.
c.greaterthanone.
d.cannotbedeterminedwithoutmoreinformation.

b49.PortagePressCompanyisconsideringreplacingamachinewithabookvalueof$200,000,aremaininguseful
lifeof5years,andannualstraightlinedepreciationof$40,000.Theexistingmachinehasacurrent
marketvalueof$200,000.Thereplacementmachinewouldcost$300,000,havea5yearlife,andsave
$100,000peryearincashoperatingcosts.Ifthereplacementmachinewouldbedepreciatedusingthe
straightlinemethodandthetaxrateis40%,whatwouldbetheincreaseinannualnetcashflowifthe
companyreplacesthemachine?
a.$60,000
b.$68,000
c.$76,000
d.$84,000

b50.WinneconneCompanyisconsideringreplacingamachinewithabookvalueof$400,000,aremaininguseful
lifeof5years,andannualstraightlinedepreciationof$80,000.Theexistingmachinehasacurrent
marketvalueof$400,000.Thereplacementmachinewouldcost$550,000,havea5yearlife,andsave
$75,000peryearincashoperatingcosts.Ifthereplacementmachinewouldbedepreciatedusingthe
straightlinemethodandthetaxrateis40%,whatwouldbethenetinvestmentrequiredtoreplacethe
existingmachine?
a.$90,000
b.$150,000
c.$330,000
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 d.$550,000

TrueFalse

T1.ThehighertheIRRonaninvestmentproject,thehigheritsprofitabilityindex.

F2.Ifthepaybackperiodofaninvestmentprojectisshorterthanitslife,theproject'sprofitabilityindex
isgreaterthan1.

F3.Ifacompanyhasdecidedthatacertaintaskmustbeperformedandthreemachinesaccomplishthattask,
themachinewiththelowestinitialcashoutlayshouldbeselected.

T4.AninvestmentwithanIRRgreaterthancostofcapitalhasaprofitabilityindexgreaterthan1.

T5.Theonlycostsandrevenuesrelevanttoareplacementdecisionarethosethatwillchangeifareplacement
ismade.

T6.Boththeincrementalandthetotalprojectapproachestoanalyzingareplacementdecisionshouldyieldthe
samedecision.

F7.BoththeIRRandthebookrateofreturnmethodsofanalyzinginvestmentsshouldyieldthesamedecision.

F8.Ifthepaybackperiodofaninvestmentisshorterthanitslife,itsprofitabilityindexisgreaterthan
l.

T9.Whencomparedwithstraightlinedepreciation,usingMACRSwillresultinalargerNPV.

F10.IRRandbookrateofreturnwillusuallyyieldthesamevalueforaninvestment.

Problems

1.StockholmCompanyisconsideringthesaleofamachinewiththefollowingcharacteristics.

Bookvalue$120,000
Remainingusefullife5years
Annualstraightlinedepreciation$24,000
Currentmarketvalue$70,000

Ifthecompanysellsthemachineitscashoperatingexpenseswillincreaseby$30,000peryearduetoan
operatinglease.Thetaxrateis40%.

a.Findthecashflowfromsellingthemachine.

b.Calculatetheincreaseinannualnetcashoutflowsasaresultofsellingthemachine.

SOLUTION:

a.Cashflowfromsale:$90,000($70,000+40%taxsavingsonthe$50,000taxloss)

b.Increaseinannualcashoutflows:$27,600($30,000pretaxcostincrease$2,400decreaseinincometaxes;
the$30,000increaseincashcostsispartiallyoffsetbylosinga$24,000depreciationdeduction)

2.PepinCompanyisconsideringreplacingamachinethathasthefollowingcharacteristics.

Bookvalue$100,000
Remainingusefullife5years
Annualstraightlinedepreciation$???
Currentmarketvalue$60,000

Thereplacementmachinewouldcost$150,000,haveafiveyearlife,andsave$50,000peryearincash
operatingcosts.Itwouldbedepreciatedusingthestraightlinemethod.Thetaxrateis40%.

a.Findthenetinvestmentrequiredtoreplacetheexistingmachine.

b.Computetheincreaseinannualincometaxesifthecompanyreplacesthemachine.

c.Computetheincreaseinannualnetcashflowsifthecompanyreplacesthemachine.

SOLUTION:

a.Netinvestment:$74,000[$150,000$60,00040%($100,00060,000)]

b.Increaseinincometaxes:$16,000[40%x($50,000pretaxflow$30,000depreciation+$20,000lost
depreciation)]

c.Increaseincashflows:$34,000($50,000$16,000increaseinincometaxes)

3.CableCompanyisconsideringthepurchaseofamachinewiththefollowingcharacteristics.

Cost$100,000
Usefullife10years
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 Expectedannualcashcostsavings$30,000

Cable'sincometaxrateis40%anditscostofcapitalis12%.Cableexpectstousestraightline
depreciationfortaxpurposes.

a.Computetheexpectedincreaseinannualnetcashflowforthisproject.

b.Computetheprofitabilityindexfortheproject.

c.HowwouldtheprofitabilityindexforthisprojectbeaffectedifCableweretouseMACRSdepreciationfor
taxpurposesandthemachinefellintothe7yearMACRSclass?(increasedecreasenotaffected)
Circletheappropriateanswer.

SOLUTION:

a.Increaseinannualnetcashflow:$22,000[$30,000(40%x($30,000$10,000)]

b.Profitabilityindex:1.24[($22,000x5.65)/$100,000]

c.Effectonprofitabilityindex:Increase(PIwouldincreasebecausethetaxshieldofdepreciationwould
occurearlierandsobemorevaluablewhenconsideringthetimevalueofmoney.)

4.FrankCo.hastheopportunitytointroduceanewproduct.Frankexpectstheproducttosellfor$60andto
haveperunitvariablecostsof$35andannualcashfixedcostsof$4,000,000.Expectedannualsalesvolume
is275,000units.Theequipmentneededtobringoutthenewproductcosts$6,000,000,hasafouryearlife
andnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.Frank'scostofcapitalis14%and
itsincometaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.Supposethatsomeofthe275,000unitsexpectedtobesoldwouldbetocustomerswhocurrentlybuyanother
ofFrank'sproducts,theX10,whichhasa$12perunitcontributionmargin.FindthesalesofX10that
canFrankloseperyearandstillhavetheinvestmentinthenewproductreturnatleastthe14%costof
capital.

d.SupposethatsellingthenewproducthasnocomplementaryeffectsbutthatFrank'sproductionengineers
anticipatesomeproductionproblemsinmakingthenewproductandarenotconfidentofthe$35estimate
ofperunitvariablecostsforthenewproduct.FindtheamountbywhichFrank'sestimateofperunit
variablecostcouldbeinerrorandtheinvestmentstillhaveareturnatleastequaltothe14%costof
capital.

SOLUTION:

a.Annualnetcashflows:$2,325,000[$2,875,000pretax40%x($2,875,000$1,500,000depreciation)]

pretaxincome=275,000x($60$35)$4,000,000=$2,875,000

b.NPV:$775,050[($2,325,000x2.914)$6,000,000]

c.AllowablelossofX10sales,approximately36,941units[($775,050/2.914)/60%]/12

d.AllowableerrorinperunitVC,$1.61

{[($775,050/2.914)/60%]/275,000units}

5.Zenexisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$240,000
Usefullife10years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
operationcosts$80,000
Additionalworkingcapitalneeded$100,000

Zenex'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.Computetheprofitabilityindexoftheproject.

SOLUTION:

a.Annualnetcashflows:$57,600[$80,000pretax40%x($80,000$24,000depreciation)]

b.NPV:$17,640[($57,600x5.650)$240,000$100,000+($100,000x.322)]

c.PI:1.052{[($57,600x5.650)+($100,000x.322)]/($240,000+$100,000)}

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6.DarwinCompanyisconsideringthesaleofamachinewiththefollowingcharacteristics.

Bookvalue$110,000
Remainingusefullife5years
Annualstraightlinedepreciation$???
Currentmarketvalue$120,000

Ifthecompanysellsthemachineitscashoperatingexpenseswillincreaseby$20,000peryear.Thetaxrate
is40%.

a.Findthecashflowfromsellingthemachine.

b.Calculatetheincreaseinannualnetcashoutflowsasaresultofsellingthemachine.

SOLUTION:

a.Cashflowfromsale:$116,000($120,00040%taxonthe$10,000taxgain)

b.Increaseinannualcashoutflows:$20,800($20,000pretaxcostincrease+$800increaseinincometaxes;
the$20,000increaseincashcostsismorethanoffsetbylosinga$22,000depreciationdeduction)

7.RuskCompanyisconsideringreplacingamachinethathasthefollowingcharacteristics.

Bookvalue$200,000
Remainingusefullife4years
Annualstraightlinedepreciation$???
Currentmarketvalue$160,000

Thereplacementmachinewouldcost$300,000,haveafouryearlife,andsave$37,500peryearincash
operatingcosts.Itwouldbedepreciatedusingthestraightlinemethod.Thetaxrateis40%.

a.Findthenetinvestmentrequiredtoreplacetheexistingmachine.

b.Computetheincreaseinannualincometaxesifthecompanyreplacesthemachine.

c.Computetheincreaseinannualnetcashflowsifthecompanyreplacesthemachine.

SOLUTION:

a.Netinvestment:$124,000[$300,000$160,00040%x($200,000160,000)]

b.Increaseinincometaxes:$5,000[40%x($37,500pretaxflow$75,000depreciation+$50,000lost
depreciation)]

c.Increaseincashflows:$32,500($37,500$5,000increaseinincometaxes)

8.ZmolekCompanyisconsideringthepurchaseofamachinecosting$700,000withausefullifeof10years.
Annualcashcostsavingsareexpectedtobe$200,000.Zmolek'sincometaxrateis40%anditscostof
capitalis12%.Zmolekexpectstousestraightlinedepreciationfortaxpurposes.

a.Computetheexpectedincreaseinannualnetcashflowforthisproject.

b.Computetheprofitabilityindexfortheproject.

SOLUTION:

a.Increaseinannualnetcashflow:$148,000[$200,00040%x($200,000$70,000)]

b.Profitabilityindex:1.19[($148,000x5.65)/$700,000]

9.RacineCo.hastheopportunitytointroduceanewproduct.Racineexpectstheprojecttosellfor$200and
tohaveperunitvariablecostsof$130andannualcashfixedcostsof$6,000,000.Expectedannualsales
volumeis125,000units.Theequipmentneededtobringoutthenewproductcosts$7,200,000,hasafour
yearlifeandnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.Workingcapitalof
$500,000wouldbenecessarytosupporttheincreasedsales.Racine'scostofcapitalis12%anditsincome
taxrateis40%.

a.ComputetheNPVofthisopportunity.

b.Computetheprofitabilityindexofthisopportunity.

SOLUTION:

a.NPV:negative$184,310

Annualcashflow:$2,370,000=60%x[125,000x($200$130)]
60%x$6,000,000+40%x$7,200,000/4

NPV:[($2,370,000x3.037)$7,200,000500,000+($500,000x.636)]

b.PI:0.976[($2,370,000x3.037+500,000x.636)/($7,200,000+500,000)]

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10.Seilerisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$2,000,000
Usefullife8years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
operationcosts$750,000
Additionalworkingcapitalneeded$500,000

Seiler'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.Computetheprofitabilityindexoftheproject.

SOLUTION:

a.Annualnetcashflows:$550,000[$750,00040%x($750,000$250,000depreciation)]

b.NPV:$434,400[($550,000x4.968)$2,000,000$500,000+($500,000x.404)]

c.PI:1.17{[($550,000x4.968)+($500,000x.404)]/($2,000,000+$500,000)}

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