Question 1

You are analyzing the purchase of new equipment.Since you are not an expert on this type of equipment,you hire a consulting firm to make recommendations.The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp.of America.The equipment costs $80,000,and it will cost another $10,000 to modify it for special use by your firm.The equipment will be depreciated on a straight-line basis over six years with no salvage value.You expect the equipment will be sold after three years for $28,000.Use of the equipment will require an increase in your company's net working capital of $4,000,but this $4,000 will be recovered at the end of year three.The use of the equipment will have no effect on revenues,but it is expected to save the firm $50,000 per year in before-tax operating costs.Your company's marginal tax rate is 35%.What is the incremental free cash flow for the first year of the project?

Accepted Answer

The answer of You are analyzing the purchase of new...

Question 2

Changes in capital spending are not incorporated directly into capital budgeting problems because the amounts are included in the operating cash flows through the inclusion of depreciation expense.

Accepted Answer

Capital spending changes are directly incorporated into capital budgeting problems as initial outlays or investments, not through operating cash flows or depreciation. Depreciation affects tax calculations but does not represent a cash outflow itself.

Question 3

Capital budgeting projects that expand sales are more likely to involve increases in working capital than are projects that involve the replacement of existing assets.

Accepted Answer

When a company undertakes capital budgeting projects that expand sales, they often require investments in inventory, accounts receivable, and other current assets to support the increased level of sales. This leads to an increase in working capital requirements. On the other hand, projects that involve the replacement of existing assets generally do not require significant changes in working capital requirements.

Question 4

The initial outlay includes the cost of purchasing the asset and getting is operational,but this excludes any training costs for employees which should be included as part of differential cash flows over the life of the project.

Accepted Answer

The statement is incorrect. Training costs for employees should be included in the initial outlay as they are part of the costs required to get the asset operational.

Question 5

TRL,Inc.has spent $2,000,000 in nonrefundable engineering fees in contemplation of building a convention center and the additional costs to complete the project are $18,000,000.The present value of all benefits the center will produce in its lifetime are $19,000,000,so TRL should not build the convention center.

Accepted Answer

The decision should be based on comparing the additional costs to complete the project ($18,000,000) with the present value of future benefits ($19,000,000), not on the sunk cost of $2,000,000 already spent on engineering fees. Since the benefits exceed the additional costs, TRL should proceed with the project.

Question 6

Blackjack Inc.wants to replace a 9-year-old machine with a new machine that is more efficient.The old machine cost $70,000 when new and has a current book value of $15,000.Blackjack can sell the machine to a foreign buyer for $14,000.Blackjack's tax rate is 35%.The effect of the sale of the old machine on the initial outlay for the new machine is

Accepted Answer

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Question 7

You are analyzing the purchase of new equipment.Since you are not an expert on this type of equipment,you hire a consulting firm to make recommendations.The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp.of America.The equipment costs $80,000,and it will cost another $10,000 to modify it for special use by your firm.The equipment will be depreciated on a straight-line basis over six years with no salvage value.You expect the equipment will be sold after three years for $28,000.Use of the equipment will require an increase in your company's net working capital of $4,000,but this $4,000 will be recovered at the end of year three.The use of the equipment will have no effect on revenues,but it is expected to save the firm $50,000 per year in before-tax operating costs.Your company's marginal tax rate is 35%.What is the initial outlay required to fund this project?

Accepted Answer

The initial outlay includes the cost of the equipment, the modification cost, and the net working capital requirement. Therefore, the initial outlay can be calculated as:
Initial Outlay = Equipment Cost + Modification Cost + Change in Net Working Capital
Initial Outlay = $80,000 + $10,000 + $4,000
Initial Outlay = $94,000
Therefore, the best choice is option D.

Question 8

Solar Confectionary develops a new candy bar and plans to sell each bar for $1.Solar predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold,and includes $1 million of incremental revenues in its capital budgeting analysis.A senior executive in the company believes that 1 million candy bars will be sold,but lowers the estimate of incremental revenue to $700,000.What would explain this change?

Accepted Answer

Cannibalization of 300,000 of Solar Confectionary's other candy bars, meaning that some customers who would have bought the other candy bars switch to the new candy bar, would reduce the incremental revenue from the new candy bar.

Question 9

An opportunity cost is a relevant incremental cost for capital budgeting decisions.

Accepted Answer

An opportunity cost is the cost of the forgone next-best alternative. In capital budgeting decisions, it is important to consider the opportunity cost of investing in one project over another, as the resources used in one project could have been used elsewhere, resulting in a different return on investment. Therefore, opportunity cost is a relevant incremental cost for capital budgeting decisions.

Question 10

Operating cash flow is equal to the change in EBIT less the change in interest expense,less the change in taxes,plus the change in depreciation.

Accepted Answer

Operating cash flow is calculated as net income plus non-cash expenses (such as depreciation and amortization) and changes in working capital, not as the change in EBIT less the change in interest expense, less the change in taxes, plus the change in depreciation.

Question 11

In general,a project's free cash flows will fall into one of three categories: (1)incremental costs,(2)sunk costs,and (3)opportunity costs.

Accepted Answer

Incremental cash flows are relevant for project evaluation, but sunk costs and opportunity costs are different concepts. Sunk costs are past costs that cannot be recovered and should not be considered in project evaluation. Opportunity costs represent the benefits foregone by choosing one alternative over another, but they are not a category of free cash flows. Free cash flows typically refer to the cash that a project is expected to generate after accounting for all expenses, including opportunity costs, but excluding sunk costs.

Question 12

Depreciation expense produces a cash inflow equal to the depreciation expense multiplied by the firm's marginal tax rate.

Accepted Answer

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Question 13

Redrock Inc.is a household products firm that is considering developing a new detergent.In evaluating whether to go ahead with the new detergent project,which of the following statements is MOST correct?

Accepted Answer

The cost of renovating the building to produce the detergent should be included in the analysis as it is a relevant cost associated with the project. Choices A and C are incorrect because both the cost of the building and labor costs are relevant costs that should be included in the analysis. Choice B is incorrect because the potential income from leasing the equipment is a relevant opportunity cost that should be included in the analysis.

Question 14

Free cash flow calculations can be broken down into three parts: cash flows from operations,cash flows associated with working-capital requirements,and financing cash flows relating to interest and dividend payments.

Accepted Answer

Free cash flow calculations typically consist of cash flows from operations and cash flows associated with investing activities (such as capital expenditures), not financing cash flows related to interest and dividend payments.

Question 15

AFB Systems is considering a new marketing campaign that will require the addition of a new computer programmer and new software.The programmer will occupy an office in AFB's current building and will be paid $8,000 per month.The software license costs $1,000 per month.The rent for the building is $4,000 per month.AFB's computer system is always on,so running the new software will not change the current monthly electric bill of $900.The incremental expenses for the new marketing campaign are

Accepted Answer

Incremental expenses are additional costs directly resulting from a new decision. Here, they include the programmer's salary ($8,000 per month) and the software license ($1,000 per month), totaling $9,000. Rent and electricity are not incremental as they do not change with the decision.

Question 16

In a replacement decision,the initial outlay is equal to the cost of the new asset less the reduction in depreciation from elimination of the old asset.

Accepted Answer

In a replacement decision, the initial outlay is equal to the cost of the new asset less the salvage value of the old asset, not the reduction in depreciation.

Question 17

A project's annual free cash flow is the change in operating cash flow less any change in net working capital and less any change in capital spending.

Accepted Answer

This is the correct definition of annual free cash flow.

Question 18

The initial outlay includes the cost of purchasing the asset and getting it operational,including the purchase price,shipping and installation,and any training costs for employees who will be operating the equipment,and any increases in working capital requirements.

Accepted Answer

The initial outlay includes all the stated expenses, hence the statement is true.

Question 19

A local restaurant owner is considering expanding into another rural area.The expansion project will be financed through a line of credit with City Bank.The administrative costs of obtaining the line of credit are $500,and the interest payments are expected to be $1,000 per month.The new restaurant will occupy an existing building that can be rented for $2,500 per month.The incremental cash flows for the new restaurant include

Accepted Answer

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Question 20

Increases in inventory and accounts receivable expected to occur if a proposed advertising campaign is undertaken are examples of sunk costs.

Accepted Answer

Increases in inventory and accounts receivable are not examples of sunk costs, as they are expected future costs that could be avoided if the advertising campaign is not undertaken. Sunk costs are costs that have already been incurred and cannot be recovered, even if the decision is made to not undertake the advertising campaign.

Quiz 11: Cash Flows and Other Topics in Capital Budgeting