Deck 6: Making Investment Decisions With the Net Present Value Rule

Question 1

The cost of a resource that may be relevant to an investment decision even when no cash changes hand is called a(n)

A)sunk cost.
B)opportunity cost.
C)depreciation cost.
D)average cost.

Answer 1

opportunity cost.

Question 2

Investment in inventories includes investment in

A)raw material only.
B)raw material and work-in-progress.
C)raw material, work-in-progress, and finished goods.
D)finished goods only.

Answer 2

raw material, work-in-progress, and finished goods.

Question 3

The Important point(s) to remember while estimating the cash flows of a project

A)is that only cash flow is relevant.
B)are cash flow is relevant and always estimate cash flows on an incremental basis.
C)are to always estimate cash flows on an incremental basis and to be consistent in the treatment of inflation.
D)are cash flow is relevant, always estimate cash flows on an incremental basis, and be consistent in the treatment of inflation.

Answer 3

are cash flow is relevant, always estimate cash flows on an incremental basis, and be consistent in the treatment of inflation.

Question 4

Money that a firm has already spent, or committed to spend regardless of whether a project is taken, is called a(n)

A)fixed cost.
B)opportunity cost.
C)sunk cost.
D)incremental cost.

Question 5

If the discount rate is stated in nominal terms, then in order to calculate the NPV in a consistent manner, the project requires that

A)cash flows be estimated in nominal terms.
B)cash flows be estimated in real terms.
C)accounting income be used.
D)cash flows be estimated ignoring inflation.

Question 6

Preferably, a financial analyst estimates cash flows for a project as

A)cash flows before taxes.
B)cash flows after taxes.
C)accounting profits before taxes.
D)accounting profits after taxes.

Question 7

Net working capital is best represented as

A)short-term assets only.
B)short-term assets and short-term liabilities.
C)long-term assets and short-term assets.
D)long-term assets and long-term liabilities.

Question 8

An analyst wishes to determine the value of resources used by a proposed project.Which values should the analyst use to approximate opportunity costs?

A)Book values
B)Market values
C)Historical values
D)Accounting values plus an inflation adjustment

Question 9

If the discount rate is stated in real terms, then in order to calculate the NPV in a consistent manner, the project requires that

A)cash flows be estimated in nominal terms.
B)cash flows be estimated in real terms.
C)accounting income be used.
D)cash flows be estimated including future inflation.

Question 10

Costs incurred as a result of past irrevocable decisions and irrelevant to future decisions are called

A)opportunity costs.
B)sunk costs.
C)incremental costs.
D)marginal costs.

Question 11

The current market value of a previously purchased machine proposed for use in a project is an example of a(n)

A)sunk cost.
B)opportunity cost.
C)fixed cost.
D)inventoriable cost.

Question 12

A reduction in the sales of existing products caused by the introduction of a new product is an example of

A)incidental effects.
B)opportunity costs.
C)sunk costs.
D)allocated overhead costs.

Question 13

When Honda develops a new engine, the incidental effects might include the following:

A)demand for replacement parts only.
B)demand for replacement parts and profits from the sale of repair services.
C)demand for replacement parts, profits from the sale of repair services, and offer modified or improved versions of the new engine for other uses.
D)demand for replacement parts and offer modified or improved versions of the new engine for other uses.

Question 14

For the case of an electric car project, which of the following costs or cash flows should be categorized as incremental when analyzing whether to invest in the project?

A)The cost of research and development undertaken for developing the electric car during the past three years
B)The annual depreciation charge
C)Tax savings resulting from the depreciation charges
D)Dividend payments

Question 15

One should consider net working capital (NWC) in project cash flows because

A)typically firms must invest cash in short-term assets to produce finished goods.
B)NWC represents sunk costs.
C)firms need positive NPV projects for investment.
D)inclusion of NWC typically increases calculated NPV.

Question 16

For the case of an electric car project, the following costs should be treated as incremental costs when deciding whether to go ahead with the project except

A)the consequent reduction in sales of the company's existing gasoline models (i.e., incidental effects).
B)interest payments on debt incurred to finance the project.
C)the value of tools that will be transferred to the project from the company's existing plants instead of being sold.
D)the expenditure on new plants and equipment.

Question 17

Accountants do not depreciate investment in net working capital because

A)it is not a cash flow.
B)it is recovered during or at the end of the project; thus it is not a depreciating asset.
C)it is a sunk cost.
D)working capital appears on the balance sheet, not the income statement.

Question 18

When a firm has the opportunity to add a project that will utilize excess factory capacity (that is currently not being used), which costs should be used to help determine if the added project should be undertaken?

A)Allocated overhead costs
B)Sunk costs
C)Incremental costs
D)Average costs

Question 19

A firm owns a building with a book value of $150,000 and a market value of $250,000.If the firm uses the building for a project, then its opportunity cost, ignoring taxes, is

A)$100,000.
B)$150,000.
C)$250,000.
D)$400,000.

Question 20

The principal short-term assets are

A)cash only.
B)cash and accounts payable only.
C)cash, accounts receivable, and inventories.
D)accounts payable only.

Question 21

A piece of capital equipment costing $400,000 today has no (zero) salvage value at the end of five years.If straight-line depreciation is used, what is the book value of the equipment at the end of three years?

A)$120,000
B)$80,000
C)$160,000
D)$240,000

Question 22

Capital equipment costing $250,000 today has $50,000 salvage value at the end of five years.If the straight-line depreciation method is used, what is the book value of the equipment at the end of two years?

A)$200,000
B)$170,000
C)$140,000
D)$150,000

Question 23

A firm has a general-purpose machine, which has a book value of $300,000 and is worth $500,000 in the market.If the tax rate is 35 percent, what is the opportunity cost of using the machine in a project?

A)$500,000
B)$430,000
C)$300,000
D)$200,000

Question 24

The real interest rate is 3 percent and the inflation rate is 5 percent.What is the nominal interest rate?

A)3.00 percent
B)5.00 percent
C)8.15 percent
D)2.00 percent

Question 25

The NPV value obtained by discounting nominal cash flows using the nominal discount rate is the same as the NPV value obtained by discounting

A)real cash flows using the real discount rate only.
B)real cash flows using the nominal discount rate only.
C)nominal cash flows using the real discount rate only.
D)real cash flows using the nominal discount rate and nominal cash flows using the real discount rate.

Question 26

If depreciation is $100,000 and the marginal tax rate is 35 percent, then the tax shield due to depreciation is

A)$35,000.
B)$100,000.
C)$65,000.
D)The answer cannot be determined from the information given.

Question 27

For project A in year 2, inventories increase by $12,000 and accounts payable increase by $2,000.Accounts receivable remain the same.Calculate the increase or decrease in net working capital for year 2.

A)Decreases by $14,000
B)Increases by $14,000
C)Decreases by $10,000
D)Increases by $10,000

Question 28

The real cash flow occurring in year 2 is $60,000.If the inflation rate is 5 percent per year and the real rate of interest is 2 percent per year, calculate the nominal cash flow for year 2.

A)$60,000
B)$62,424
C)$66,150
D)$63,654

Question 29

Suppose that a project has a depreciable investment of $1,000,000 and falls under the following MACRS year 5 class depreciation schedule: year 1: 20 percent; year 2: 32 percent; year 3: 19.2 percent; year 4: 11.5 percent; year 5: 11.5 percent; and year 6: 5.8 percent.
Calculate the depreciation tax shield for year 2 using a tax rate of 30 percent.

A)$224,000
B)$60,000
C)$96,000
D)$300,000

Question 30

The real rate of interest is 3 percent and inflation is 4 percent.What is the nominal rate of interest?

A)3.00 percent
B)1.00 percent
C)7.12 percent
D)-1.00 percent

Question 31

A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years .The corporate tax rate is 30 percent.The assets will depreciate using the MACRS 3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%).The company's tax situation is such that it can use all applicable tax shields.The opportunity cost of capital is 12 percent.Assume that the asset can sell for book value at the end of the project.Calculate the NPV of the project (approximately).

A)$22,463
B)$19,315
C)$16,244
D)$5,721

Question 32

Your firm expects to receive a cash flow in two years of $10,816 in nominal terms.If the real rate of interest is 2 percent and the inflation rate is 4 percent, what is the real cash flow for year 2?

A)$11,236
B)$10,816
C)$10,000
D)$9,246

Question 33

If the nominal interest rate is 7.5 percent and the inflation rate is 4.0 percent, what is the real interest rate?

A)4.0 percent
B)9.5 percent
C)3.4 percent
D)11.5 percent

Question 34

Suppose that a project has a depreciable investment of $600,000 and falls under the following MACRS year 5 class depreciation schedule: year 1: 20 percent; year 2: 32 percent; year 3: 19.2 percent; year 4: 11.5 percent; year 5: 11.5 percent; and year 6: 5.8 percent.
Calculate depreciation for year 2.

A)$120,000
B)$192,000
C)$96,000
D)$115,200

Question 35

Proper treatment of inflation in NPV calculations involves

A)discounting nominal cash flows by the nominal discount rate.
B)discounting real cash flows by the real discount rate.
C)discounting nominal cash flows by the real discount rate.
D)discounting nominal cash flows by the nominal discount rate and discounting real cash flows by the real discount rate.

Question 36

Given the following data for Project M calculate the NPV of the project.
$\begin{array} { c c c } &\mathrm { C } _ { 6 } & \mathrm { C } _ { 1 } & \mathrm { C } _ { 2 } \\ \text {Cash flow in nominal terms:}&- 100 & 75 & 60 \\\text {Real discount rate = 5 \%}\\\text {Nominal discount rate = 10 \%}\\\end{array}$

A)$25.85
B)$17.77
C)$22.65
D)$35.00

Question 37

Given the following data for Project M calculate the NPV of the project. $\begin{array} { l l l c } \text { Cash flow in real terms: } & \mathrm { C } _ { 0 } & \mathrm { C } _ { 1 } & \mathrm { C } _ { 2 } \\\text { Real discount rate } = 5 \% & - 200 & 150 & 120 \\\text { Nominal discount rate } = 10 \% & & &\end{array}$

A)$51.70
B)$35.54
C)$45.21
D)$70.00

Question 38

If depreciation is $600,000 and the marginal tax rate is 35 percent, then the tax shield due to depreciation is

A)$210,000.
B)$600,000.
C)$390,000.
D)The answer cannot be determined from the information given.

Question 39

For project Z, year 5 inventories increase by $6,000; accounts receivable by $4,000; and accounts payable by $3,000.Calculate the increase or decrease in working capital for year 5.

A)Increases by $5,000
B)Decreases by $1,000
C)Increases by $7,000
D)Decreases by $7,000

Question 40

Working capital is a frequent source of errors in estimating project cash flows.These errors include

A)forgetting about working capital entirely and forgetting that working capital may change during the life of the project.
B)forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting that working capital is recovered at the end of the project.
C)forgetting that working capital may change during the life of the project, forgetting that working capital is recovered at the end of the project, and forgetting to depreciate working capital.
D)forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting to depreciate working capital.

Question 41

Germany allows firms to choose the depreciation method(s) of

A)straight-line method only.
B)declining-balance method only.
C)straight-line method and declining-balance method.
D)Germany allows a very different system.

Question 42

Sunk costs are bygones (i.e., they are unaffected by the decision to accept or reject a project).They should therefore be ignored.

Question 43

RainMan Inc.is in the business of producing rain upon request.They must decide between two investment projects: a new airplane for seeding rain clouds or a new weather control machine built by Dr.Nutzbaum.The discount rate for the new airplane is 9 percent, while the discount rate for the weather machine is 39 percent (it happens to have higher market risk).Which investment should the company select and why? (Assume a 0 percent inflation rate and that projected costs do not change over time.) $\begin{array} { cc c } \text { Year } & \text { Airplane } & \text { Weather Machine } \\0 & - 900 & - 900 \\1 & 500 & 550 \\2 & 600 & 600 \\3 & & 685\end{array}$

A)Airplane, because it has a higher NPV
B)Weather machine, because it has a higher NPV
C)Airplane, because it has a higher equivalent annual cash flow
D)Weather machine, because it has a higher equivalent annual cash flow

Question 44

Two mutually exclusive projects have the following positive NPVs and project lives. $\begin{array} { r c c } \text { Project } & \text { NPV } & \text { Life } \\\text { Project A } & \$ 5,000 & \text { 3 years } \\\text { Project B } & \$ 6,500 & \text { 5 years }\end{array}$ If the cost of capital were 15 percent, which project would you accept?

A)Project A, because it has higher EAC
B)Project B, because it has higher EAC
C)Project A, because its NPV can be earned more quickly
D)Project B, because it has higher NPV

Question 45

Two machines, A and B, which perform the same functions, have the following costs and lives. $\begin{array} { c c c } \text { Type } & \text { PV Costs } & \text { Life } \\\text { Machine A } & \$ 6,000 & 5 \\\text { Machine B } & \$ 8,000 & 7\end{array}$ Which machine would you choose? The two machines are mutually exclusive and the cost of capital is 15 percent.

A)Machine A, because the EAC is $1,789.89
B)Machine B, because the EAC is $1,922.88
C)Machine A, because it has lower PV costs
D)Machine B, because it has longer life

Question 46

You are considering the purchase of one of two machines required in your production process.Machine A has a life of two years.Machine A costs $50 initially and then $70 per year in maintenance.Machine B has an initial cost of $90.It requires $40 in maintenance for each year of its three-year life.Either machine must be replaced at the end of its life.Which is the better machine for the firm? The discount rate is 15 percent and the tax rate is zero.

A)Machine A, because EAC for machine A is $100.76
B)Machine B, because EAC for machine B is $79.42
C)Machine A, because PV of costs for machine A is $163.80
D)Machine B, because PV of costs for machine B is $181.33

Question 47

When calculating cash flows, one should consider them on an incremental basis.

Question 48

Your boss asked you to evaluate a project with an infinite life.Sales and costs project to $1,000 and $500 per year, respectively.(Assume sales and costs occur at the end of the year [i.e., profit of $500 at the end of year one]).There is no depreciation and the tax rate is 30 percent.The real required rate of return is 10 percent.The inflation rate is 4 percent and is expected to be 4 percent forever.Sales and costs will increase at the rate of inflation.If the project costs $3,000, what is the NPV?

A)$500.00
B)$1,629.62
C)$365.38
D)$472.22

Question 49

By undertaking an analysis in real terms, the financial manager avoids having to forecast inflation.

Question 50

Which of the following countries allows firms to keep two separate sets of books, one for the stockholders and one for the tax authorities like the Internal Revenue Service?

A)United States only
B)United States and Japan
C)United States, Japan, and France
D)None of these options are correct.

Question 51

Working capital is needed for additional investment within a project and should be included within cash-flow estimates.

Question 52

Using the technique of equivalent annual cash flows and a discount rate of 7 percent, what is the value of the following project? $\begin{array} { l l l l l l } \text { Year } & 0 & 1 & 2 & 3 & 4 \\\text { CF } & - 22 & 8 & 9 & 11 & 13\end{array}$

A)3.06
B)3.61
C)10.25
D)12.23

Question 53

Working capital is one of the most common sources of mistakes in estimating project cash flows.

Question 54

When calculating cash flows, one should consider all incidental effects.

Question 55

A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years .The corporate tax rate is 30 percent.The assets will depreciate using the MACRS year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%).The company's tax situation is such that it can use all applicable tax shields.The opportunity cost of capital is 11 percent.Assume that the asset can sell for book value at the end of the project.Calculate the approximate IRR for the project.

A)12.00 percent
B)11.00 percent
C)17.73 percent
D)14.06 percent

Question 56

OM Construction Company must choose between two types of cranes.Crane A costs $600,000, will last for five years, and will require $60,000 in maintenance each year.Crane B costs $750,000, will last for seven years, and will require $30,000 in maintenance each year.Maintenance costs for cranes A and B occur at the end of each year.The appropriate discount rate is 12 percent per year.Which machine should OM Construction purchase?

A)Crane A, because EAC is $226,444
B)Crane B, because EAC is $194,336
C)Crane A, because its PV is $816,286 (i.e., less than the PV of Project B)
D)The answer cannot be calculated because the revenues for the project are not given.

Question 57

Opportunity costs should not be included in project analysis, as they are missed opportunities.

Question 58

Depreciation expense acts as a tax shield in reducing taxes.

Question 59

A project requires an investment of $900 today.It can generate sales of $1,100 per year forever.Costs are $600 for the first year and will increase by 20 percent per year.(Assume all sales and costs occur at year-end [i.e., costs are $600 @ t = 1].) The project can be terminated at any time without cost.Ignore taxes and calculate the NPV of the project at a 12 percent discount rate.

A)$65.00
B)$57.51
C)$100.00
D)It cannot be calculated as g > r.

Question 60

A financial analyst should include interest and dividend payments when calculating a project's cash flows.

Question 61

How do you compare projects with different lives?

Question 62

Briefly discuss how tax reporting to governments versus shareholders is treated in countries like Japan.

Question 63

Briefly explain how the decision to replace an existing machine is made.

Question 64

You should replace a machine when the EAC of continuing to operate it exceeds the EAC of the new machine.

Question 65

Define the term cash flow for a project.

Question 66

Briefly explain how inflation is treated consistently while estimating a project's NPV.

Question 67

The equivalent annual cash-flow technique is primarily used whenever the lives of two different projects are the same.

Question 68

What are some of the additional factors that an analyst should consider while estimating cash flows in foreign countries and currencies?

Question 69

Briefly explain the acronym MACRS.

Question 70

Most large U.S.corporations keep two separate sets of books, one for stockholders and one for the Internal Revenue Service.

Question 71

The rule for comparing machines with different lives is to select the machine with the greatest equivalent annual cost (EAC).

Question 72

What are some of the important points to remember while estimating the cash flows of a project?
Estimate after-tax cash flows on an incremental basis.
Include all incidental effects.
Include working capital requirements.
Include opportunity costs.
Do not include sunk costs.
Take inflation into consideration in a consistent manner.

Question 73

Within the MACRS system of depreciation, most industrial equipment falls into the 10-15 year classes.

Question 74

Briefly explain how the cost of excess capacity is taken into consideration.

Question 75

When evaluating mutually exclusive projects with positive NPV but different life spans, the proper technique to employ is the equivalent annual cash-flow approach.

Question 76

A financial analyst can use the equivalent annual cash-flow approach to determine the year in which an existing machine can be profitably replaced with a new machine.