Deck 13: Capital Budgeting: Cash Flows and Risk

Question 1

When calculating the cash flows for a project, you should include interest payments.

Answer 1

False

Question 2

Changes in net operating working capital do not need to be considered in capital budgeting cash flow analysis as long as the nominal (undiscounted) values of the changes are identical in each time period.

Answer 2

False

Question 3

The lower the correlation of a project's cash flows with those of the rest of the firm, the greater will be the benefits of the project with regard to reducing within-firm risk.

Answer 3

True

Question 4

A project's market risk rises if the correlation of its cash flows with the economy decreases.

Question 5

If an asset being considered for acquisi¬tion has beta of zero, its purchase will have no effect on the firm's market risk.

Question 6

In cash flow estimation, the presence of externalities has no direct cash flow effects.

Question 7

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in the analysis.

Question 8

Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.

Question 9

Estimating project cash flows is considered the most important and the most difficult step in the capital budgeting process. Both the number of variables and the interdepartmental nature of the process contribute to the difficulty of estimating cash flows.

Question 10

Externalities present in projects being considered in capital budgeting are very difficult to quantify and as a result of this, they should be excluded from the financial analyses.

Question 11

The primary advantage of accelerated depreciation over straight-line depreciation is that the total, undiscounted, depreciation tax savings over the life of the project are greater when an accelerated depreciation method is used.

Question 12

With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital budgeting project.

Question 13

A firm which bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses MACRS accelerated depreciation than if it uses the optional straight-line alternative, other things being equal.

Question 14

Any cash flow that can be classified as incremental is relevant in a capital budgeting project analysis.

Question 15

Risky projects can be evaluated by discounting expected cash flows using a risk-adjusted discount rate.

Question 16

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR (or modified IRR) is greater than the firm's weighted average cost of capital.

Question 17

Quantification of risk is the easiest part of incorporating risk into capital budgeting.

Question 18

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Question 19

Net incremental cash flow is calculated by adding back the change in depreciation to the change in net income.

Question 20

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

Question 21

Superior analytical techniques, such as NPV, used in combination with cost of capital adjustments, can overcome the problem of poor cash flow estimation in decision making.

Question 22

Opportunity costs include those cash inflows that could be generated from assets the firm already owns, if those assets are not used for the project being evaluated.

Question 23

Which of the following is not a cash flow that results from the decision to accept a project?

A) Changes in working capital.
B) Shipping and installation costs.
C) Sunk costs.
D) Opportunity costs.
E) Externalities.

Question 24

Adams Audio is considering whether to make an investment in a new type of technology. Which of the following factors should the company consider when it decides whether to undertake the investment?

A) The company has already spent $3 million researching the technology.
B) The new technology will affect the cash flows produced by its other operations.
C) If the investment is not made, then the company will be able to sell one of its laboratories for $2 million.
D) All of the factors above should be considered.
E) Factors b and c should be considered.

Question 25

A company is considering an expansion project. The company's CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the company's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

A) Any sunk costs associated with the project.
B) Any interest expenses associated with the project.
C) Any opportunity costs associated with the project.
D) Answers b and c are correct.
E) All of the answers above are correct.

Question 26

Other things held constant, which of the following would increase the NPV of a project being considered?

A) A shift from MACRS to straight-line depreciation.
B) Making the initial investment in the first year rather than spreading it over the first 3 years.
C) A decrease in the discount rate associated with the project.
D) The sale of the old machine in a replacement decision at a capital loss rather than at book value.
E) An increase in required working capital.

Question 27

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are more risky.

Question 28

Which of the following statements is correct?

A) Well diversified stockholders do not consider corporate risk when determining required rates of return.
B) Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.
C) Managers care only about market risk.
D) Market risk is important but does not have a direct effect on stock price because it only affects beta.
E) All of the statements above are false.

Question 29

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, for the duration of a project's life, other things held constant.

Question 30

The change in net operating working capital is always positive, meaning more working capital is required for projects considered in capital budgeting because all projects are either expansion projects or replacement projects which have expansion effects.

Question 31

Suppose a firm is considering production of a new product whose projected sales include sales that will be taken away from another product the firm also produces. The lost sales on the existing product are a sunk cost and are not a relevant cost to the new product.

Question 32

If a project is small relative to the total firm, and if its returns are not highly correlated with the returns on the firm's other assets, then the project may not be very risky in either the within-firm (corporate) or the market risk sense, even if the returns on the project are highly uncertain and thus the project has a high degree of stand-alone risk.

Question 33

Twin Hills Inc. is considering a proposed project. Given available information, it is currently estimated that the proposed project is risky but has a positive net present value. Which of the following factors would make the company less likely to adopt the current project?

A) It is revealed that if the company proceeds with the proposed project, the company will lose two other accounts, both of which have positive NPVs.
B) It is revealed that the company has an option to back out of the project 2 years from now, if it is discovered to be unprofitable.
C) It is revealed that if the company proceeds with the project, it will have an option to repeat the project 4 years from now.
D) Answers a and b are correct.
E) Answers b and c are correct.

Question 34

Which of the following statements is most correct?

A) Sunk costs should be incorporated into capital budgeting decisions.
B) Opportunity costs should be incorporated into capital budgeting decisions.
C) Relevant externalities should be incorporated into capital budgeting decisions.
D) Answers b and c are correct.
E) Answers a, b, and c are correct.

Question 35

A company is considering a proposed expansion to its facilities. Which of the following statements is most correct?

A) In calculating the project's operating cash flows, the firm should not subtract out financing costs such as interest expense, since these costs are already included in the WACC, which is used to discount the project's net cash flows.
B) Since depreciation is a non-cash expense, the firm does not need to know the depreciation rate when calculating the operating cash flows.
C) When estimating the project's operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flows from externalities since they are accounted for elsewhere.
D) Statements a and c are correct.
E) None of the statements above is correct.

Question 36

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales. Other things held constant, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the less risky the project.

Question 37

When evaluating a new project, the firm should consider all of the following factors except:

A) Changes in working capital attributable to the project.
B) Previous expenditures associated with a market test to determine the feasibility of the project, if the expenditures have been expensed for tax purposes.
C) The current market value of any equipment to be replaced.
D) The resulting difference in depreciation expense if the project involves replacement.
E) All of the statements above should be considered.

Question 38

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1) capital budgeting decisions must be based on accounting income, and (2) only incremental cash flows are relevant to accept/reject decisions.

Question 39

Which of the following statements is most correct?

A) The rate of depreciation will often affect operating cash flows, even though depreciation is not a cash expense.
B) Corporations should fully account for sunk costs when making investment decisions.
C) Corporations should fully account for opportunity costs when making investment decisions.
D) All of the answers above are correct.
E) Answers a and c are correct.

Question 40

It is extremely difficult to estimate the revenues and costs associated with large complex projects that take several years to develop. This is why subjective judgement is recommended for such projects instead of cash flow analysis.

Question 41

Which of the following statements is correct?

A) Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
B) In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's NPV.
C) The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done using a PC with a spreadsheet program or even a calculator.
D) Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to changes in key variables and the likely range of variable values.
E) Answers c and d are correct.

Question 42

Which of the following is not considered a relevant concern in deter- mining incremental cash flows for a new product?

A) The use of factory floor space which is currently unused but available for production of any product.
B) Revenues from the existing product that would be lost as a result of some customers switching to the new product.
C) Shipping and installation costs associated with preparing the machine to be used to produce the new product.
D) The cost of a product analysis completed in the previous tax year and specific to the new product.
E) None of the above. (All are relevant concerns in estimating relevant cash flows attributable to a new-product project.)

Question 43

Project X has an up-front cost of $1 million, whereas Project Y has an up-front cost of only $200,000. Both projects last five years and provide positive cash flows in Years 1-5. Project X is riskier; its risk-adjusted WACC is 12 percent. Project Y is safer; its risk-adjusted WACC is 8 percent. After discounting each of the project's cash flows at the project's risk-adjusted WACC, you find that Project X has a NPV of $20,000, and Project Y has a NPV of $15,000. The projects are mutually exclusive and cannot be repeated. The firm is not capital constrained; it can raise as much capital as it needs, provided it has profitable projects in which to invest. Given this information, which of the following statements is most correct?

A) The firm should select Project Y because it has a higher return; ($15,000/$200,000) is greater than ($20,000/$1,000,000).
B) The firm should select Project X because it has a higher NPV.
C) The firm should select Project Y because it is less risky.
D) The firm should reject both projects because their IRRs are less than the risk-adjusted WACC.
E) Statements a and c are correct.
Medium

Question 44

The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of expected life remaining and a current book value of $30,000 versus a current market value of $24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value, what is the initial after-tax outlay for the new printing machine?

A) -$22,180
B) -$30,000
C) -$33,600
D) -$36,000
E) -$40,000

Question 45

Which of the following constitutes an example of a cost which is not incremental, and therefore not relevant in an accept/reject decision?

A) A firm has a parcel of land that can be used for a new plant site or, alternatively, can be used to grow watermelons.
B) A firm can produce a new cleaning product that will generate new sales, but some of the new sales will be from customers who switch from another product the company currently produces.
C) A firm orders and receives a piece of new equipment which is shipped across the country and requires $25,000 in installation and set-up costs.
D) All of the above are not examples of incremental cash flows.
E) Answers a, b, and c are examples of incremental cash flows, and therefore, relevant cash flows.

Question 46

Risk in a revenue-producing project can best be adjusted for by

A) Ignoring it.
B) Adjusting the discount rate upward for increasing risk.
C) Adjusting the discount rate downward for increasing risk.
D) Picking a risk factor equal to the average discount rate.
E) Reducing the NPV by 10 percent for risky projects.

Question 47

Which of the following statement completions is incorrect? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce

A) Higher depreciation charges in the early years of an asset's life.
B) Larger cash flows in the earlier years of an asset's life.
C) Larger total undiscounted profits from the project over the project's life.
D) Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes.
E) None of the above. (All of the above are correct.)

Question 48

A company estimates that an average-risk project has a WACC of 10 percent, a below-average-risk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?

A) Project A has average risk and an IRR = 9 percent.
B) Project B has below-average risk and an IRR = 8.5 percent.
C) Project C has above-average risk and an IRR = 11 percent.
D) All of the projects above should be accepted.
E) None of the projects above should be accepted.

Question 49

Which of the following statements is correct?

A) An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project.
B) Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions.
C) It is unrealistic to expect that increases in net operating working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project.
D) Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value.
E) All of the statements above are false.

Question 50

If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most likely become

A) Riskier over time, and its value will decline.
B) Riskier over time, and its value will rise.
C) Less risky over time, and its value will rise.
D) Less risky over time, and its value will decline.
E) There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.

Question 51

In theory, the decision maker should view market risk as being of primary importance. However, within-firm, or corporate, risk is relevant to a firm's

A) Well-diversified stockholders, because it may affect debt capacity and operating income.
B) Management, because it affects job stability.
C) Creditors, because it affects the firm's credit worthiness.
D) All of the answers above are correct.
E) Only answers a and c are correct.

Question 52

Which of the following statements is most correct?

A) Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same.
B) In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital.
C) When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment.
D) All of the answers above are correct.
E) None of the answers above is correct.

Question 53

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

A) Increase the IRR of the asset to reflect the greater risk.
B) Increase the NPV of the asset to reflect the greater risk.
C) Reject the asset, since its acceptance would increase the risk of the firm.
D) Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.
E) Increase the cost of capital used to evaluate the project to reflect the higher risk of the proj¬ect.

Question 54

Regarding the net present value of a replacement decision, which of the following statements is false?

A) The present value of the after tax cost reduction benefits resulting from the new investment is treated as an inflow.
B) The after-tax market value of the old equipment is treated as an inflow at t = 0.
C) The present value of depreciation expenses on the new equipment, multiplied by the tax rate, is treated as an inflow.
D) Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0.
E) An increase in net operating working capital is treated as an outflow when the project begins and as an inflow when the project ends.

Question 55

Sanford & Son Inc. is thinking about expanding their business by opening another shop on property they purchased 10 years ago. Which of the following items should be included in the analysis of this endeavor?

A) The property was cleared of trees and brush 5 years ago at a cost of $5,000.
B) The new shop is expected to affect the profitability of the existing shop since some current customers will transfer their business to the new shop. Sanford and Son estimate that profits at the existing shop will decrease by 10 percent.
C) Sanford & Son can lease the entire property to another company (that wants to grow flowers on the lot) for $5,000 per year.
D) Both statements b and c should be included in the analysis.
E) All of the statements above should be included in the analysis.

Question 56

Monte Carlo simulation

A) Can be useful for estimating a project's stand-alone risk.
B) Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable.
C) Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
D) All of the answers above.
E) Only answers a and b are correct.

Question 57

(3)2). Which of the following statements is correct?

A) In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV.
B) The preceding statement would be true if "upward" were replaced with "downward."
C) The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities.
D) If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration.
E) The rent referred to in statement d is a sunk cost, and as such it should be ignored.

Question 58

If a company uses the same discount rate for evaluating all projects, which of the following results is likely?

A) Accepting poor, high-risk projects.
B) Rejecting good, low-risk projects.
C) Accepting only good, low-risk projects.
D) Accepting no projects.
E) Answers a and b are correct.

Question 59

Pickles Corp. is a company which sells bottled iced tea. The company is thinking about expanding its operations into the bottled lemonade business. Which of the following factors should the company incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business?

A) If the company enters the lemonade business, its iced tea sales are expected to fall 5 percent as some consumers switch from iced tea to lemonade.
B) Two years ago the company spent $3 million to renovate a building for a proposed project which was never undertaken. If the project is adopted, the plan is to have the lemonade produced in this building.
C) If the company doesn't produce lemonade, it can lease the building to another company and receive after-tax cash flows of $500,000 a year.
D) All of the statements above are correct.
E) Answers a and c are correct.

Question 60

Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

A) Be correct.
B) Be biased downward.
C) Be biased upward.
D) Possibly have a bias, but it could be upward or downward.
E) More information is needed; otherwise, we can make no reasonable statement.

Question 61

After a long drought, the manager of Long Branch Farm is considering the installation of an irrigation system which will cost $100,000. It is estimated that the irrigation system will increase revenues by $20,500 annually, although operating expenses other than depreciation will also increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5 years) to a zero salvage value. If the tax rate on ordinary income is 40 percent, what is the project's IRR?

A) 12.6%
B) -1.3%
C) 13.0%
D) 10.2%
E) -4.8%

Question 62

Consider the following project data: (1) A $500 feasibility study will be conducted at t = 0.
(2) If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not.
(3) If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor.
(4) If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.

A) -$35
B) -$12
C) $ 0
D) $12
E) $35

Question 63

Parker Products manufactures a variety of household products. The company is considering introducing a new detergent. The company's CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.)• The project has an anticipated economic life of 4 years. • The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0)• If the company goes ahead with the proposed product, it will have an effect on the company's net operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after the project is completed.
• The detergent is expected to generate sales revenue of $1 million the first year (t = 1)• The company's interest expense each year will be $100,000.
• The new detergent is expected to reduce the after-tax cash flows of the company's existing products by $250,000 a year (t = 1, 2, 3, and 4)• The company's overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project's WACC is estimated to be 12 percent.
• The company's tax rate is 40 percent.
What is the net present value of the proposed project?

A) -$ 765,903.97
B) -$1,006,659.58
C) -$ 824,418.62
D) -$ 838,997.89
E) -$ 778,583.43

Question 64

What is the project's NPV?

A) $2,622
B) $2,803
C) $2,917
D) $5,712
E) $6,438

Question 65

What is the total value of the terminal year non-operating cash flows at the end of Year 3?

A) $18,120
B) $19,000
C) $21,000
D) $25,000
E) $27,000

Question 66

Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's cost is $40,000, what is the project's NPV?

A) $1,014
B) $2,292
C) $7,550
D) $ 817
E) $5,040

Question 67

Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent to evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects of more or less risk. Currently, two mutually exclusive projects are under consideration. Both have a cost of $200,000 and will last 4 years. Project A, a riskier-than-average project, will produce annual end of year cash flows of $71,104. Project B, of less than average risk, will produce cash flows of $146,411 at the end of Years 3 and 4 only. Virus Stopper should accept

A) B with a NPV of $10,001.
B) Both A and B because both have NPVs greater than zero.
C) B with a NPV of $8,042.
D) A with a NPV of $7,177.
E) A with a NPV of $15,968.

Question 68

Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent cost of capital. Inflation is zero. What is the project's NPV?

A) $ 7,673.71
B) $12,851.75
C) $17,436.84
D) $24,989.67
E) $32,784.25

Question 69

What is the operating cash flow in Year 2?

A) $ 9,000
B) $10,240
C) $11,687
D) $13,453
E) $16,200

Question 70

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net operating working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.
What is the total terminal (non-operating) cash flow at the end of Year 3?

A) $10,000
B) $12,000
C) $15,680
D) $16,000
E) $18,000

Question 71

Pierce Products is deciding whether it makes sense to purchase a new piece of equipment. The equipment costs $100,000 (payable at t = 0)t = 1: 0.33 t = 2: 0.45
T = 3: 0.15
T = 4: 0.07
At the end of four years the company expects to be able to sell the equipment for a salvage value of $10,000 (after-tax). The company is in the 40 percent tax bracket. The company has an after-tax cost of capital of 11 percent. Since there is more uncertainty about the salvage value, the company has chosen to discount the salvage value at 12 percent. What is the net present value of purchasing the equipment?

A) $ 9,140.78
B) $16,498.72
C) $20,564.23
D) $22,853.90
E) $28.982.64

Question 72

Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average, its fresh produce division has average risk, and its institutional foods division has below-average risk. Dandy adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is the risk-adjusted required rate of return for a low-risk project in the yogurt division?

A) 6%
B) 8%
C) 10%
D) 12%
E) 14%

Question 73

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net operating working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.
What is the net investment in the truck? (That is, what is the Year 0 net cash flow?)

A) -$50,000
B) -$52,600
C) -$55,800
D) -$62,000
E) -$65,000

Question 74

California Mining is evaluating the introduction of a new ore production process. Two alter¬natives are available. Production Process A has an initial cost of $25,000, a 4-year life, and a $5,000 net salvage value, and the use of Process A will increase net cash flow by $13,000 per year for each of the 4 years that the equipment is in use. Produc¬tion Process B also requires an initial invest¬ment of $25,000, will also last 4 years, and its expected net salvage value is zero, but Process B will increase net cash flow by $15,247 per year. Management believes that a risk-adjusted dis¬count rate of 12 percent should be used for Process A. If California Mining is to be indifferent between the two processes, what risk-adjusted dis¬count rate must be used to evaluate B?

A) 8%
B) 10%
C) 12%
D) 14%
E) 16%

Question 75

Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative, and a 10 percent cost of capital. Inflation is zero. What is the project's NPV?

A) $ 6.24
B) $ 7.89
C) $ 8.87
D) $ 9.15
E) $10.41

Question 76

The truck's cost of capital is 10 percent. What is its NPV?

A) -$1,547
B) -$ 562
C) $ 0
D) $ 562
E) $1,034
 

Question 77

What is the net investment required at t = 0?

A) -$42,000
B) -$40,000
C) -$38,600
D) -$37,600
E) -$36,600

Question 78

The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive projects. The discount rate used for Project A is 12 percent. Further, Project A costs $15,000, and it would be depreciated using MACRS. It is expected to have an after-tax salvage value of $5,000 at the end of 6 years and to produce after-tax cash flows (including depreciation) of $4,000 for each of the 6 years. Project B costs $14,815 and would also be depreciated using MACRS. B is expected to have a zero salvage value at the end of its 6-year life and to produce after-tax cash flows (including depreciation) of $5,100 each year for 6 years. The Unlimited's marginal tax rate is 40 percent. What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?

A) 15%
B) 16%
C) 18%
D) 20%
E) 12%

Question 79

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net operating working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.
What is the operating cash flow in Year 1?

A) $17,820
B) $18,254
C) $19,920
D) $20,121
E) $21,737

Question 80

Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to be able to reduce net operating working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years. Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects of this nature. If the machine costs $60,000, what is the project's NPV?

A) -$15,394
B) -$14,093
C) -$58,512
D) -$21,493
E) -$46,901