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Multiple Choice
1. Which of the following groups of capital budgeting techniques uses the time value of money?
a. Book rate of return, payback, and profitability index.
b. IRR, payback, and NPV.
c. IRR, NPV, and profitability index.
d. IRR, book rate of return, and profitability index.
2. Discounted cash flow techniques for analyzing capital budgeting decisions are NOT normally applied to projects
a. requiring no investment after the first year of life.
b. having useful lives shorter than one year.
c. that are essential to the business.
d. involving replacement of existing assets.
4. Companies using MACRS for tax purposes and straight-line depreciation for financial reporting purposes
usually find that the relationship between the tax basis and book value of their assets is
a. the tax basis is lower than book value.
b. the tax basis is higher than book value.
c. the tax basis is the same as book value.
d. none of the above.
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7. In choosing from among mutually exclusive investments the manager should normally select the one with the
highest
a. NPV.
b. IRR.
c. profitability index.
d. book rate of return.
8. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
a. The expected resale price of the existing machine.
b. The book value of the existing machine.
c. The original cost of the existing machine.
d. The depreciated cost of the existing machine.
9. A company is considering replacing a machine with one that will save $50,000 per year in cash operating costs
and have $20,000 more depreciation expense per year than the existing machine. The tax rate is 40%.
Buying the new machine will increase annual net cash flows of the company by
a. $38,000.
b. $30,000.
c. $20,000.1
d. $12,000.
11. A major difference between an investment in working capital and one in depreciable assets is that
a. an investment in working capital is never returned, while most depreciable assets have some residual value.
b. an investment in working capital is returned in full at the end of a project's life, while an investment in
depreciable assets has no residual value.
c. an investment in working capital is not tax-deductible when made, nor taxable when returned, while an
investment in depreciable assets does allow tax deductions.
d. because an investment in working capital is usually returned in full at the end of the project's life, it is ignored
in computing the amount of the investment required for the project.
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13. If a company uses a five-year MACRS period to depreciate assets instead of a 10-year life with straight-line
depreciation,
a. the NPV of the investment is higher.
b. the IRR of the investment is lower.
c. there is no difference in either NPV or IRR.
d. total cash flows over the useful life would be lower.
17. Which of the following makes investments more desirable than they had been?
a. An increase in the income tax rate.
b. An increase in interest rates.
c. An increase in the number of years over which assets must be depreciated.
d. None of the above.
20. With respect to income taxes, the principal advantage of MACRS over straight-line depreciation is that
a. total taxes will be lower under MACRS.
b. taxes will be constant from year to year under MACRS.
c. taxes will be lower in the earlier years under MACRS.
d. taxes will decline in future years under MACRS.
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Profitability Index NPV IRR
------------------- -------- -------------------------
a. greater than 1 positive equals cost of capital
b. greater than 1 negative less than cost of capital
c. less than 1 negative less than cost of capital
d. less than 1 positive less than cost of capital
26. Because of idle capacity, a company is considering two assets for sale. They are identical in all respects except
that asset A has a higher tax basis than asset B. Only one need be sold now and the market price is the same
for both assets. Which of the following is true?
a. The cash flow is greater from selling asset A.
b. The cash flow is greater from selling asset B.
c. The cash flow is the same no matter which one is sold.
d. It is not possible to determine how the cash flows from sales of the assets will differ.
27. If the tax law were changed so that owners of apartment buildings had to depreciate them over 50 years instead
of the current 31.5 years,
a. rents would rise.
b. rents would fall because annual depreciation charges would fall.
c. rents would stay about the same.
d. more people would invest in apartment buildings.
28. Which statement could express the results of a sensitivity analysis of an investment decision?
a. The NPV of the project is $50,000.
b. A 5% decline in volume will make the project unprofitable.
c. This project ranks third out of the five available.
d. This project does not meet the cutoff rate of return.
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29. XYZ Co. is adopting just-in-time principles. When evaluating an investment project that would reduce
inventory, how should XYZ treat the reduction?
a. Ignore it.
b. Decrease the cost of the investment and decrease cash flows at the end of the project's life.
c. Decrease the cost of the investment.
d. Decrease the cost of the investment and increase the cash flow at the end of the project's life.
30. Which of the following combinations of capital budgeting techniques includes only discounted cash flow
techniques?
a. Book rate of return, payback, and profitability index.
b. NPV, IRR, and profitability index.
c. IRR, payback, and NPV.
d. Profitability index, NPV, and payback.
32. In connection with a capital budgeting project, an investment in working capital is normally recovered
a. at the end of the project's life.
b. in the first year of the project's life.
c. evenly through the project's life.
d. when the company goes out of business.
33. For investments that have only costs (no revenues or cost savings), an appropriate decision rule is to accept the
project that has the
a. longest payback period.
b. lowest present value of cash outflows.
c. higher present value of future cash outflows.
d. lowest internal rate of return.
34. The cash inflow from the return of an investment in working capital is
a. adjusted for taxes due.
b. discounted to present value.
c. ignored if any depreciable assets also involved in the project have no expected residual value.
d. not real.
35. NPV is appropriate to use to analyze which decision relating to a joint-products company?
a. Whether or not to sell facilities now used for additional processing of one of the joint products.
b. Whether or not to acquire facilities needed for additional processing of one of the joint products.
c. Whether or not to sell facilities now used to operate the joint process.
d. All of the above.
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36. If X Co. expects to get a one-year bank loan to help cover the initial financing of capital project Q, the analysis
of Q should
a. offset the loan against any investment in inventory or receivables required by the project.
b. show the loan as an increase in the investment.
c. show the loan as a cash outflow in the second year of the project's life.
d. ignore the loan.
38. A company evaluates a project using straight-line depreciation over its 10-year estimated useful life and then
reevaluates it using a 7-year MACRS class life. The second analysis will show
a. a lower IRR for the project.
b. the same NPV and IRR for the project.
c. a higher NPV for the project.
d. lower total cash flows over the 10 years.
39. Assuming that a project has already been evaluated using the following techniques, the evaluation under which
technique is least likely to be affected by an increase in the estimated residual value of the project?
a. Payback period.
b. IRR.
c. NPV.
d. PI.
42. Acme is considering the sale of a machine with a book value of $160,000 and 3 years remaining in its useful
life. Straight-line depreciation of $50,000 annually is available. The machine has a current market value of
$200,000. What is the cash flow from selling the machine if the tax rate is 40%?
a. $50,000
b. $160,000
c. $184,000
d. $200,000
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43. Hoff is considering the sale of a machine with a book value of $160,000 and 3 years remaining in its useful life.
Straight-line depreciation of $50,000 annually is available. The machine has a current market value of
$100,000. What is the cash flow from selling the machine if the tax rate is 40%?
a. $50,000
b. $100,000
c. $124,000
d. $160,000
44. Altoona Company is considering replacing a machine with a book value of $200,000, a remaining useful life of
4 years, and annual straight-line depreciation of $50,000. The existing machine has a current market value
of $175,000. The replacement machine would cost $320,000, have a 4 year life, and save $100,000 per year
in cash operating costs. If the replacement machine would be depreciated using the straight-line method
and the tax rate is 40%, what would be the increase in annual income taxes if the company replaces the
machine?
a. $28,000
b. $40,000
c. $42,000
d. $64,000
45. An investment opportunity costing $300,000 is expected to yield net cash flows of $100,000 annually for
five years. The profitability index of the investment at a cutoff rate of 14% would be
a. 3.0.
b. 1.14.
c. 0.33.
d. 14%.
46. A project has a NPV of $30,000 when the cutoff rate is 10%. The annual cash flows are $41,010 on an
investment of $100,000. The profitability index for this project is
a. 1.367.
b. 3.333.
c. 2.438.
d. 1.300.
47. A project has an IRR in excess of the cost of capital. The profitability index for this project would be
a. less than zero.
b. between zero and one.
c. greater than one.
d. cannot be determined without more information.
48. A project has an IRR less than the cost of capital. The profitability index for this project would be
a. less than zero.
b. between zero and one.
c. greater than one.
d. cannot be determined without more information.
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49. Portage Press Company is considering replacing a machine with a book value of $200,000, a remaining useful
life of 5 years, and annual straight-line depreciation of $40,000. The existing machine has a current market
value of $200,000. The replacement machine would cost $300,000, have a 5-year life, and save $100,000
per year in cash operating costs. If the replacement machine would be depreciated using the straight-line
method and the tax rate is 40%, what would be the increase in annual net cash flow if the company replaces
the machine?
a. $60,000
b. $68,000
c. $76,000
d. $84,000
50. Winneconne Company is considering replacing a machine with a book value of $400,000, a remaining useful
life of 5 years, and annual straight-line depreciation of $80,000. The existing machine has a current market
value of $400,000. The replacement machine would cost $550,000, have a 5-year life, and save $75,000 per
year in cash operating costs. If the replacement machine would be depreciated using the straight-line
method and the tax rate is 40%, what would be the net investment required to replace the existing machine?
a. $90,000
b. $150,000
c. $330,000
d. $550,000
True-False
T 1. The higher the IRR on an investment project, the higher its profitability index.
F 2. If the payback period of an investment project is shorter than its life, the project's profitability index is greater
than 1.
F 3. If a company has decided that a certain task must be performed and three machines accomplish that task, the
machine with the lowest initial cash outlay should be selected.
T 4. An investment with an IRR greater than cost of capital has a profitability index greater than 1.
T 5. The only costs and revenues relevant to a replacement decision are those that will change if a replacement is
made.
T 6. Both the incremental and the total-project approaches to analyzing a replacement decision should yield the
same decision.
F 7. Both the IRR and the book rate of return methods of analyzing investments should yield the same decision.
F 8. If the payback period of an investment is shorter than its life, its profitability index is greater than l.
T 9. When compared with straight-line depreciation, using MACRS will result in a larger NPV.
F 10. IRR and book rate of return will usually yield the same value for an investment.
Problems
1. Stockholm Company is considering the sale of a machine with the following characteristics.
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Annual straight-line depreciation $ 24,000
Current market value $ 70,000
If the company sells the machine its cash operating expenses will increase by $30,000 per year due to an operating
lease. The tax rate is 40%.
b. Calculate the increase in annual net cash outflows as a result of selling the machine.
SOLUTION:
a. Cash flow from sale: $90,000 ($70,000 + 40% tax savings on the $50,000 tax loss)
b. Increase in annual cash outflows: $27,600 ($30,000 pretax cost increase - $2,400 decrease in income taxes; the
$30,000 increase in cash costs is partially offset by losing a $24,000 depreciation deduction)
2. Pepin Company is considering replacing a machine that has the following characteristics.
The replacement machine would cost $150,000, have a five-year life, and save $50,000 per year in cash
operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.
b. Compute the increase in annual income taxes if the company replaces the machine.
c. Compute the increase in annual net cash flows if the company replaces the machine.
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SOLUTION:
b. Increase in income taxes: $16,000 [40% x ($50,000 pretax flow - $30,000 depreciation + $20,000 lost
depreciation)]
3. Cable Company is considering the purchase of a machine with the following characteristics.
Cost $100,000
Useful life 10 years
Expected annual cash cost savings $30,000
Cable's income tax rate is 40% and its cost of capital is 12%. Cable expects to use straight-line depreciation for
tax purposes.
a. Compute the expected increase in annual net cash flow for this project.
c. How would the profitability index for this project be affected if Cable were to use MACRS depreciation for tax
purposes and the machine fell into the 7-year MACRS class? (increase decrease not affected) Circle the
appropriate answer.
SOLUTION:
a. Increase in annual net cash flow: $22,000 [$30,000 - (40% x ($30,000 - $10,000)]
c. Effect on profitability index: Increase (PI would increase because the tax shield of depreciation would occur
earlier and so be more valuable when considering the time value of money.)
4. Frank Co. has the opportunity to introduce a new product. Frank expects the product to sell for $60 and to have
per-unit variable costs of $35 and annual cash fixed costs of $4,000,000. Expected annual sales volume is
275,000 units. The equipment needed to bring out the new product costs $6,000,000, has a four-year life and no
salvage value, and would be depreciated on a straight-line basis. Frank's cost of capital is 14% and its income
tax rate is 40%.
c. Suppose that some of the 275,000 units expected to be sold would be to customers who currently buy another of
Frank's products, the X-10, which has a $12 per-unit contribution margin. Find the sales of X-10 that can
Frank lose per year and still have the investment in the new product return at least the 14% cost of capital.
d. Suppose that selling the new product has no complementary effects but that Frank's production engineers
anticipate some production problems in making the new product and are not confident of the $35 estimate
of per-unit variable costs for the new product. Find the amount by which Frank's estimate of per-unit
variable cost could be in error and the investment still have a return at least equal to the 14% cost of capital.
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SOLUTION:
a. Annual net cash flows: $2,325,000 [$2,875,000 pretax - 40% x ($2,875,000 - $1,500,000 depreciation)]
{[($775,050/2.914)/60%]/275,000 units}
Cost $240,000
Useful life 10 years
Annual straight-line depreciation $ ???
Expected annual savings in cash
operation costs $ 80,000
Additional working capital needed $100,000
SOLUTION:
a. Annual net cash flows: $57,600 [$80,000 pretax - 40% x ($80,000 - $24,000 depreciation)]
6. Darwin Company is considering the sale of a machine with the following characteristics.
If the company sells the machine its cash operating expenses will increase by $20,000 per year. The tax rate is
40%.
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b. Calculate the increase in annual net cash outflows as a result of selling the machine.
SOLUTION:
a. Cash flow from sale: $116,000 ($120,000 - 40% tax on the $10,000 tax gain)
b. Increase in annual cash outflows: $20,800 ($20,000 pretax cost increase + $800 increase in income taxes; the
$20,000 increase in cash costs is more than offset by losing a $22,000 depreciation deduction)
7. Rusk Company is considering replacing a machine that has the following characteristics.
The replacement machine would cost $300,000, have a four-year life, and save $37,500 per year in cash
operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.
b. Compute the increase in annual income taxes if the company replaces the machine.
c. Compute the increase in annual net cash flows if the company replaces the machine.
SOLUTION:
b. Increase in income taxes: $5,000 [40% x ($37,500 pretax flow - $75,000 depreciation + $50,000 lost
depreciation)]
8. Zmolek Company is considering the purchase of a machine costing $700,000 with a useful life of 10 years.
Annual cash cost savings are expected to be $200,000. Zmolek's income tax rate is 40% and its cost of capital is
12%. Zmolek expects to use straight-line depreciation for tax purposes.
a. Compute the expected increase in annual net cash flow for this project.
SOLUTION:
a. Increase in annual net cash flow: $148,000 [$200,000 - 40% x ($200,000 - $70,000)]
9. Racine Co. has the opportunity to introduce a new product. Racine expects the project to sell for $200 and to
have per-unit variable costs of $130 and annual cash fixed costs of $6,000,000. Expected annual sales volume
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is 125,000 units. The equipment needed to bring out the new product costs $7,200,000, has a four-year life and
no salvage value, and would be depreciated on a straight-line basis. Working capital of $500,000 would be
necessary to support the increased sales. Racine's cost of capital is 12% and its income tax rate is 40%.
SOLUTION:
Cost $2,000,000
Useful life 8 years
Annual straight-line depreciation $ ???
Expected annual savings in cash
operation costs $ 750,000
Additional working capital needed $ 500,000
SOLUTION:
a. Annual net cash flows: $550,000 [$750,000 - 40% x ($750,000 - $250,000 depreciation)]
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