Deck 9: Using Discounted Cash Flow Analysis to Make Investment Decisions

Question 1

Sunk costs remain the same whether or not you accept the project.

Answer 1

True

Question 2

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows.

Answer 2

False

Question 3

If a project permits a reduction in the level of working capital, this reduction is assumed to increase cash flows.

Answer 3

True

Question 4

Suppose you finance a project partly with debt, you should neither subtract the debt proceeds from the required investment, nor would you recognize the interest and principal payments on the debt as cash outflows.

Question 5

Sunk costs influence capital budgeting decisions when the sunk costs exceed future cash inflows.

Question 6

Upon the sale of equipment at the end of its useful life, tax liability will be incurred whenever the book value of the equipment exceeds the sales price.

Question 7

Cash flow from operations = (revenues-cash expenses) × (1-tax rate) + (depreciation × tax rate).

Question 8

Capital budgeting analysis focuses on profits as opposed to cash flows.

Question 9

In project analysis, allocations of overhead should be limited to only those that represent additional expense.

Question 10

Discounting real cash flows with real interest rates gives an overly optimistic idea of a project's value.

Question 11

The total depreciation tax shield equals the product of depreciation and the tax rate.

Question 12

What is the undiscounted cash flow in the final year of an investment, assuming: 10,000 after-tax cash flows from operations, the fully depreciated machine, the sole asset in the pool, is sold for $1,000, the project had required $2,000 in additional working capital, and a 35 percent tax rate?

A)$8,450
B)$12,600
C)$12,650
D)$14,000

Question 13

An asset's CCA class number affects its CCA dollar deduction amount from taxable income.

Question 14

Opportunity costs are evaluated for investment decisions at their historical (that is, book) cost.

Question 15

When an asset class is terminated, there will be recaptured depreciation when the adjusted cost of disposal from UCC of the asset class is a negative balance.

Question 16

When additional funds must be committed to working capital, those funds are assumed to be recovered at the end of the project's life.

Question 17

Sunk costs do not affect project NPV.

Question 18

When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them.

Question 19

The method of financing a project affects the determination of its cash flows for capital budgeting purposes.

Question 20

As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected.

Question 21

What is the amount of the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35 percent marginal tax rate?

A)$260,000
B)$325,000
C)$360,000
D)$425,000

Question 22

At current prices and a 13 percent cost of capital, a project's NPV is $100,000.By what minimum amount must the initial cost of the project decrease (revenues will be unchanged) before you would prefer to wait two years before investing?

A)$21,685
B)$26,000
C)$27,690
D)$29,380

Question 23

What nominal annual return is required on an investment in order that an investor experiences a 12 percent gain in purchasing power? Assume inflation to be 4 percent.

A)7.69 percent
B)9.29 percent
C)12.00 percent
D)16.48 percent

Question 24

What is the net effect on a firm's working capital if a new project requires: $30,000 increase in inventory, $10,000 increase in accounts receivable, $25,000 increase in machinery, and a $20,000 increase in accounts payable?

A)- $5,000
B)+ $10,000
C)+ $20,000
D)+ $45,000

Question 25

Your forecast shows $500,000 annually in sales for each of the next three years.If your second and third year predictions have failed to incorporate 5 percent expected annual inflation, how far off in total dollars is your three-year forecast?

A)$25,000
B)$50,000
C)$52,550
D)$76,250

Question 26

What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense and a 35 percent marginal tax rate?

A)$26,250
B)$43,750
C)$70,000
D)$75,000

Question 27

A firm generates sales of $250,000, depreciation expense of $50,000, taxable income of $50,000, and has a 35 percent tax rate.By how much does net cash flow deviate from net income?

A)$17,500
B)$50,000
C)$67,500
D)$82,500

Question 28

Which of the following statements is correct?

A)real cash flows must be discounted at a real discount rate
B)nominal cash flows must be discounted at a nominal rate
C)(1 + real rate of interest) = (1 + nominal rate of interest)/(1 + inflation rate)
D)all statements are correct

Question 29

For a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense, the depreciation tax shield would be:

A)$10,500.
B)$30,000.
C)$35,000.
D)$65,000.

Question 30

A project that increased sales was accompanied by a $50,000 increase in inventory, a $20,000 increase in accounts receivable, and a $25,000 increase in accounts payable.Assuming these amounts remain constant, by how much has net working capital increased?

A)$5,000
B)$25,000
C)$30,000
D)$45,000

Question 31

For a profitable firm in the 35 percent marginal tax bracket with $100,000 of annual depreciation expense, the depreciation tax shield would be:

A)$10,500.
B)$30,000.
C)$35,000.
D)$65,000.

Question 32

Which of the following is not accurate in depicting cash flows from operations?

A)(Revenues - expenses) (1 - tax rate) + (depreciation × tax rate)
B)(Revenues - expenses - taxes paid)
C)(Net profit + depreciation)
D)(Revenues - cash expenses - taxes paid)

Question 33

What is the present value at a 10 percent discount rate of the depreciation tax shield for a firm in the 35 percent tax bracket that purchases a $50,000 asset being depreciated at 15 percent declining balance with a half-year rule, disposed from the existing asset pool at zero?

A)$10,866
B)$10,023
C)$17,500
D)$37,908

Question 34

What is the NPV of a project that costs $100,000, provides $23,000 in cash flows annually for six years, requires a $5,000 increase in net working capital, and depreciates the asset at 15 percent declining balance over six years and sold at zero salvage value? The discount rate is 14 percent.The tax rate is 40 percent.

A)-$23,460
B)-$13,283
C)$13,283
D)$44,866

Question 35

Your forecast shows $500,000 annually in sales for each of the next three years.If your second and third year predictions have failed to incorporate 2.5% expected annual inflation, how far off in total dollars is your three-year forecast?

A)$37,813
B)$50,000
C)$52,550
D)$76,250

Question 36

What is the NPV of a project that costs $100,000, provides $23,000 in cash flows annually for six years, requires a $5,000 increase in net working capital, and depreciates the asset straight line over six years while ignoring the half-year convention? The discount rate is 14%.

A)-$15,561
B)-$13,283
C)$13,283
D)$15,561

Question 37

Assume your firm has an unused machine that originally cost $75,000, has a book value of $20,000, and is currently worth $25,000.Ignoring taxes, the correct opportunity cost for this machine in capital budgeting decisions is:

A)$75,000.
B)$25,000.
C)$20,000.
D)$5,000.

Question 38

A parcel of corporate land was recently dedicated as the new plant site.What cost allocation should the land receive, based on the following: original cost of $200,000, market value of $300,000, net book value of $200,000, a recent offer to purchase for $250,000?

A)$200,000
B)$250,000
C)$275,000
D)$300,000

Question 39

A project anticipates net cash flows of $10,000 at the end of year one, with such amount growing at the expected 5 percent rate of inflation over the subsequent four years.Calculate the real present value of this five-year cash stream if the firm employs a nominal discount rate of 15 percent.

A)$33,522
B)$38,377
C)$43,294
D)$55,000

Question 40

What rate of nominal growth is expected in sales if they are currently $1,000,000 and expected to reach $1,600,000 in five years?

A)3.20 percent
B)9.86 percent
C)12.00 percent
D)16.00 percent

Question 41

When assets are sold from a CCA pool:

A)other assets' values increase.
B)the assets sold continue in the pool.
C)a new rate is used in the pool.
D)the remaining pool is subject to the net acquisitions rule.

Question 42

In capital budgeting analysis, an increase in working capital can be shown as:

A)a cash inflow at the beginning of the project.
B)an outflow at the beginning and an equal inflow at the end of the project.
C)an inflow at the beginning and an equal outflow at the end of the project.
D)a decrease in the initial amount invested.

Question 43

Capital budgeting proposals should be evaluated as if the project were financed:

A)entirely by debt.
B)entirely by equity.
C)half by debt and half by equity.
D)with the highest cost source of funds, to be safe.

Question 44

A cost should be considered sunk when it:

A)is fully depreciated.
B)produces no additional sales revenues.
C)has no effect on future flows.
D)is replaced by costs that are not yet sunk.

Question 45

Which of the following would be more likely to make an unacceptable project appear acceptable?

A)discounting real cash flows with real rates.
B)discounting nominal cash flows with real rates.
C)discounting real cash flows with nominal rates.
D)discounting nominal cash flows with nominal rates.

Question 46

A tax shield is equal to the reduction in:

A)tax liability resulting from a deductible expense.
B)taxable income resulting from a deductible expense.
C)cash flow from an expense.
D)net income.

Question 47

Which of the following typically results from using straight-line depreciation in the set of books for shareholders?

A)net income appears higher during the early periods of depreciation.
B)less money is paid to the Canada Revenue Agency.
C)financial managers have more funds from operations available.
D)depreciable assets last for a longer period of time.

Question 48

An investment today of $25,000 promises to return $10,000 annually for the next three years.What is the approximate real rate of return on this investment if inflation averages 6 percent annually during the period?

A)3.5 percent
B)9.7 percent
C)14.0 percent
D)20.0 percent

Question 49

Opportunity costs for organizational resources:

A)are limited to the explicit cash flows involved.
B)are determined according to the marginal tax rate.
C)can involve no cash flows.
D)should not be determined for existing products.

Question 50

Which of the following changes in working capital is least likely, given an increase in the overall level of sales?

A)an increase in inventories
B)an increase in accounts payable
C)a decrease in accounts receivable
D)a decrease in accruals

Question 51

Which of the following costs probably should not be allocated to the investment needed for a new project?

A)increase in accounts receivable.
B)new warehouse, built for this project.
C)25 percent of the vice president's salary.
D)labour expense for employees in new warehouse.

Question 52

Projects that are calculated as having negative NPVs should be:

A)depreciated over a longer time period.
B)charged less in overhead costs.
C)discounted using lower rates.
D)rejected or abandoned.

Question 53

The additional inventory investment that is often required for new projects can be partially funded by:

A)switching to accelerated depreciation methods.
B)reducing accounts receivable.
C)decreasing equipment purchases.
D)increasing accounts payable.

Question 54

Changes in net working capital can occur at:

A)the beginning of a project.
B)the end of a project.
C)any time during the life of a project.
D)the beginning of any accounting period.

Question 55

With the half-year rule, the depreciation percentage is lower in the first year than in the second year.This is due to the fact that:

A)the depreciation percentage increases in each year.
B)assets are assumed to be acquired at mid-year.
C)depreciation expense increases at the rate of inflation.
D)declining balance depreciation is less attractive than straight-line depreciation.

Question 56

A new project requires an increase in both current assets and current liabilities of $125,000 each.What is the overall impact on net working capital investment?

A)an increase of zero.
B)an increase of $125,000.
C)an increase of $250,000.
D)an increase of $62,500, when averaged over the life of the project.

Question 57

The primary difficulty in the allocation of overhead costs to prospective projects is that the:

A)allocation will reduce the project's NPV.
B)discount rate is unknown.
C)costs may not represent an incremental expense.
D)expenses may have been previously allocated.

Question 58

The value of a proposed capital budgeting project depends upon the:

A)total cash flows produced.
B)incremental cash flows produced.
C)accounting profits produced.
D)increase in total sales produced.

Question 59

Higher depreciation rates:

A)allow more depreciation over the asset's life.
B)decrease the CCA depreciation tax shield.
C)Have no effect on the CCA tax shield.
D)allow assets to be depreciated more rapidly.

Question 60

The likely effect of discounting nominal cash flows with real interest rates will be to:

A)make an investment's NPV appear more attractive.
B)make an investment's NPV appear less attractive.
C)correctly calculate an investment's NPV if inflation is expected.
D)correctly calculate an investment's NPV, regardless of expected inflation.

Question 61

Which of the following statements is most likely to be correct for a project in which the NPV is negative when based on the inflows from net income?

A)NPV may turn positive after adjusting for depreciation expense.
B)NPV should be calculated with pretax cash flows.
C)NPV has probably been overestimated.
D)The project should be rejected or abandoned.

Question 62

If the adoption of a new product will reduce the sales of an existing product, then the:

A)new product should not be undertaken.
B)old product should be abandoned.
C)incremental benefits of the new product may be overestimated.
D)incremental benefits of the new product may be underestimated.

Question 63

The rationale for not including sunk costs in capital budgeting decisions is that they:

A)are usually small in magnitude.
B)revert at the end of the investment.
C)have no incremental effect.
D)reduce the estimated NPV.

Question 64

Why is it fairly easy to fall into the trap of discounting real cash flows with nominal rates?

A)it is difficult to determine real discount rates.
B)increases in nominal cash flows are often not forecast.
C)inflation does not impact cash flows, but it does impact discount rates.
D)increases in revenues are offset by increases in costs.

Question 65

Which of the following represents a common reason for increases in net working capital with new projects?

A)inventory can now be held at lower levels
B)accounts receivable are often not paid on time
C)inventory increases more than accounts payable increase
D)accounts payable must be increased

Question 66

The opportunity cost of an asset:

A)should be depreciated annually.
B)can differ depending on market conditions.
C)is typically ignored in capital budgeting.
D)is important only for parcels of land.

Question 67

A new, more efficient machine will last four years and allow inventory levels to decrease by $100,000 during its life.At a cost of capital of 13 percent, how does the net working capital change affect the project's NPV?

A)NPV increases by $38,668
B)NPV increases by $61,330
C)NPV increases by $100,000
D)NPV increases by $138,668

Question 68

Assuming that an asset has been fully depreciated according to its straight line CCA class, which of the following statements is correct concerning the value of the asset:

A)its market value is zero.
B)its UCC value is zero.
C)its book value is the current market value.
D)it has neither book value nor market value.

Question 69

If a project is expected to increase inventory by $15,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000, what effect does working capital have during the life of the project?

A)increases investment by $4,000
B)increases investment by $5,000
C)increases investment by $6,000
D)working capital has no effect during the life of the project

Question 70

The correct method to handle overhead costs in capital budgeting is to:

A)allocate a portion to each project.
B)allocate them to projects with the highest NPVs.
C)ignore all except identifiable incremental amounts.
D)ignore them in all cases.

Question 71

When is it appropriate to include sunk costs in the evaluation of a project?

A)include sunk costs when they are relatively large
B)include sunk costs if it improves the project's NPV
C)include sunk costs if they are considered to be overhead costs
D)it is never appropriate to include sunk costs

Question 72

How does net working capital affect the NPV of a five-year project if working capital is expected to increase by $25,000 and the firm has a 15% cost of capital?

A)NPV will increase by $9,322
B)NPV will increase by $12,571
C)NPV will decrease by $25,000
D)NPV will decrease by $12,571

Question 73

Why is it likely that firms would use straight-line depreciation methods for depicting project analysis to shareholders or lenders, if such choice were possible?

A)it increases the NPV of the project.
B)it decreases the tax liability of the project.
C)it mirrors the market value of the assets.
D)it allows asset balances to decline more slowly.

Question 74

When the real rate of interest is less than the nominal rate of interest, then:

A)inflation must be added to the nominal rate.
B)investment returns do not increase purchasing power.
C)nominal flows should be discounted with real rates.
D)inflation is expected to occur.

Question 75

Assume that sales revenues are increasing more rapidly than product costs, but that a project's cash flows have been represented as an annuity when calculating NPV.Which of the following problems may occur?

A)nominal cash flows are possibly being discounted with a real rate.
B)real cash flows are possibly being discounted with a nominal rate.
C)nominal cash flows are possibly being discounted with a nominal rate.
D)real cash flows are possibly being discounted with a real rate.

Question 76

The "recovery" of an additional investment in working capital is assumed to:

A)occur at the end of the project's life.
B)occur at the beginning of the project's life.
C)occur whenever the project first shows a profit.
D)be a sunk cost.

Question 77

The present value at any given discount rate of the depreciation tax shield is:

A)equal for all depreciation methods.
B)higher with MACRS than straight-line depreciation.
C)higher for the tenth year than the seven-year recovery period class.
D)likely to increase annually due to inflation.

Question 78

In what manner does depreciation expense affect investment projects?

A)it reduces cash flows by the amount of the depreciation expense.
B)it increases cash flows by the amount of the depreciation expense.
C)it reduces taxable income by the amount of the depreciation expense.
D)it reduces taxes by the amount of the depreciation expense.

Question 79

Working capital will affect incremental cash flows if:

A)current liabilities change more than current assets.
B)current assets change more than current liabilities.
C)inventory changes from previous levels.
D)net working capital changes from previous levels.

Question 80

Capital budgeting projects typically assume that all cash flows transpire at the end of the year.The reason for this is that:

A)less tax liability results from this practice.
B)balance sheets are prepared at the end of the year.
C)it is easier for the analyst in this manner.
D)most corporations collect their cash at the end of the year.