Deck 11: Cash Flows and Capital Budgeting

Question 1

The stand-alone principle says that we can treat a project as if it were a stand-alone firm that has its own revenue, expenses, and investment requirements.

Answer 1

True

Question 2

The term incremental in the context of incremental after-tax free cash flows refers to the fact that the firm's total after-tax free cash flows will change if the new project is not adopted.

Answer 2

False

Question 3

The research and development costs to date of a project should be considered when analyzing the cash flows of a prospective project.

Answer 3

False

Question 4

The impact of a project on another project's free cash flows should be ignored.

Question 5

Accounting earnings are a reliable measure of the costs and benefits of a project.

Question 6

Evaluate the following statement: When analyzing a project, if the expected future cash flows are denominated in nominal dollars, then the discount rate should represent a nominal rate as well.

Question 7

Allocated costs such as corporate overhead should be included in free cash flow calculations.

Question 8

Conceptually, free cash flows are what is left over for distribution to creditors and stockholders after the firm has made the necessary investments in working capital and long-term assets.

Question 9

Increases in working capital are considered cash flows associated with short term investments.

Question 10

Opportunity costs should always be included in a project's projected free cash flow.

Question 11

Incremental cash flow from operations is the cash flow from a project that is expected to be generated after all operating expenses have been paid.

Question 12

If you add depreciation and amortization to incremental net operating profits after tax (NOPAT), then you will obtain incremental cash flow from operations.

Question 13

If a firm expects to increase its investment in inventory due to a prospective project, then this is an example of an incremental capital expenditure.

Question 14

Free cash flow equals cash flow from operations minus required investments.

Question 15

If taken without accompanying changes in cash flow, changes in a company's accounting earnings do not affect the overall value of the firm.

Question 16

The purchase of a factory building is an example of an incremental addition to working capital.

Question 17

Evaluate the following statement: Nominal interest rates do not incorporate the expected rate of inflation.

Question 18

Evaluate the following statement: BioGeological Pharmaceuticals invested $100 million on a heart drug that does not prevent heart disease. BioGeological has since found that the drug does prevent diabetes. When considering whether to market the drug as a diabetic panacea, the firm should include the $100 million spent while investigating the heart-related effects.

Question 19

Evaluate the following statement: Since our perspective when evaluating a project is that of the shareholders only, then we should use the after-tax cash flows produced by a project.

Question 20

Evaluate the following statement: Since our perspective when evaluating a project is that of all of the investors in the firm, creditors as well as stockholders, then we should use the pre-tax cash flows produced by the project. .

Question 21

The NPV of a project includes:

A) discounting the expected cash flows of a project in the future.
B) discounting only the certain cash flows of a project in the future.
C) discounting the variance of the expected cash flows of a project in the future.
D) None of the above.

Question 22

Evaluate the following statement: A progressive tax system means that a taxpayer will pay a higher tax rate for a given dollar of earnings for every successive year.

Question 23

Evaluate the following statement: The expected cash flows for a project are fixed amounts that have zero variability in the projected values.

Question 24

The term ___________ refers to the fact that these cash flows reflect the amount by which the firm's total after-tax free cash flows will change if the project is adopted.

A) Periodic
B) ending cash flows
C) Incremental
D) None of the above.

Question 25

Evaluate the following statement: It is possible for a firm to have one depreciation schedule for tax purposes and another for financial reporting purposes.

Question 26

_________ refers to the cash flow that a project is expected to generate after all operating expenses and taxes have been paid.

A) Incremental cash flow from operations
B) Operating income
C) EBITDA
D) None of the above.

Question 27

Evaluate the following statement: The unadjusted NPVs of two projects with different useful lives can be compared to determine which project is the better of the two.

Question 28

Evaluate the following statement: Terminal-year free cash flows may differ from the cash flows provided in the typical year of a project for reasons such as the return/repayment of increases/reductions in additional working capital in the prior years.

Question 29

Evaluate the following statement: If the salvage value is less than the book value of the asset at the time of an asset disposition , then the firm will effectively receive a positive cash flow from taxes on the sale.

Question 30

Evaluate the following statement: You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately under all circumstances.

Question 31

In order to calculate free cash flow by starting with incremental cash flow from operations, we should

A) subtract the incremental capital expenditures and add the incremental additions to working capital.
B) add the incremental capital expenditures and the incremental additions to working capital.
C) subtract the incremental capital expenditures and the incremental additions to working capital.
D) None of the above.

Question 32

The firm's ____________ is used to calculate NOPAT because the profits from a project are assumed to be incremental to the firm.

A) average tax rate
B) marginal tax rate
C) lowest marginal tax rate
D) None of the above.

Question 33

The cash flows used in capital budgeting calculations are based on:

A) historical estimates.
B) forecasts of future cash revenues, expenses, and investment outlays.
C) forecasts of net income.
D) forecasts of retained earnings available for financing projects.

Question 34

Additions to tangible assets, intangible assets, and current assets can be described as:

A) cash flows associated with investments.
B) operating cash flows.
C) free cash flows.
D) None of the above.

Question 35

Evaluate the following statement: When forecasting operating expenses, analysts distinguish between fixed costs which vary with sales and variable costs which do not.

Question 36

Evaluate the following statement: The MACRS depreciation tax schedule for three-year equipment provides a depreciation rate for a total of three years.

Question 37

Evaluate the following statement: If the current market price of corn is $100 per bushel and the nominal rate of interest is 10 percent, then the nominal price of corn next period should also be $100.

Question 38

Evaluate the following statement: You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately if the current NPV of the project is positive.

Question 39

The ___________ is intended to reconcile changes in the balance sheet cash accounts.

A) capital budgeting cash flow calculation
B) accounting statement of cash flows
C) accounting statement of income
D) None of the above.

Question 40

The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as:

A) the stand-alone principle.
B) the dependent principle.
C) the independent principle.
D) None of the above.

Question 41

A tax system in which taxpayers pay a progressively larger share of their income in taxes as their income rises is called:

A) a flat tax system.
B) a progressive tax system.
C) a digressive tax system.
D) a political tax system.

Question 42

If inflation is anticipated to be 10 percent during the next year while a nominal rate of 20 percent will be earned on U.S. Treasury bills, then what is the accurate real rate of return on these securities?(Round final percentage answer to decimal places.)

A) 20.05%
B) 10.01%
C) 9.09%
D) None of the above.

Question 43

Windy Burgers is trying to determine when to harvest a herd of cows that it currently owns. If it harvests the herd in year 1, the NPV of the project would increase over an immediate harvest by 25 percent. A year 2 harvest would create an NPV increase of 15 percent over that of year 1 and year 3 would create an NPV increase of 7 percent over that of year 2. If the cost of capital is 12 percent for Windy, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.
B) Harvest in year 1.
C) Harvest in year 2.
D) Harvest in year 3.

Question 44

If Company Xhas the option of leasing some factory space to Company Y or utilizing it for another product line, then how should Company X handle the lost lease payments on the factory space if it chooses the product line?

A) Ignore it.
B) Include it as an opportunity cost.
C) Include half of it as additional revenue for the project.
D) None of the above.

Question 45

When deciding to select one project or another where the projects have different useful lives, then you could utilize:

A) a repeated investment analysis to decide which project is better for the firm.
B) an equivalent annual annuity analysis to decide which project is better for the firm.
C) Either of the above.
D) None of the above.

Question 46

For a U.S. corporation with income above $20 million,

A) the average tax rate is less than the marginal tax rate.
B) the average tax rate is equal to the marginal tax rate.
C) the average tax rate is greater than the marginal tax rate.
D) None of the above.

Question 47

Which of the following should not be included in a project's cash flow calculations?

A) cash expenses
B) cash revenues
C) allocated expenses
D) None of the above.

Question 48

Which of the following is the best example of a sunk cost?

A) Future payments on a leased building.
B) Future research and development costs.
C) Historical research and development costs.
D) Historical noncash expenses.

Question 49

In order for a project to generate a positive net working capital cash flow at the end of its useful life,

A) the project must have generated a cumulative negative cash flow during the life of the project.
B) the project must have generated a cumulative positive cash flow during the life of the project.
C) the project must have generated a cumulative negative cash flow at the conclusion of the project.
D) the project could not have generated a positive cash flow at the opening of the project.

Question 50

_____________ represent dollars stated in terms of constant purchasing power.

A) Nominal dollars
B) Real dollars
C) Inflated dollars
D) None of the above

Question 51

In project analysis, corporate overhead allocations should only be taken into account on if:

A) the firm is currently covering all of its overhead allocations.
B) the firm is currently unable to cover all of its overhead allocations.
C) the overhead allocations involve cash expenditures.
D) None of the above.

Question 52

If you are discounting a project's cash flows using the nominal cost of capital, then that means that you have taken _______ into account:

A) the real rate of return.
B) the expected rate of inflation.
C) Both of the above.
D) None of the above.

Question 53

A firm is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. The project would also reduce the cash revenues of an existing project by $2 million. What is the free cash flow on the project, per year, if the firm is in the 40 percent marginal tax rate?

A) $2.4 million
B) $3.4 million
C) $4.6 million
D) $5.0 million

Question 54

Brown Mack, Inc., currently has two large manufacturing divisions that share a single plant. Brown Mack owns the plant but has calculated that $6 million of overhead expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a third manufacturing division, of equal size to the other two divisions, then what overhead cost should the new division take into account on its capital budgeting cash flow analysis?

A) $0
B) $2 million
C) $3 million
D) $6 million

Question 55

Whenever a project has a negative impact on an existing project's cash flows, then that effect should:

A) be ignored.
B) be ignored if the project is evaluated using the correct cost of capital.
C) be included as a negative revenue amount on the new project's cash flow analysis.
D) be included if the impact is limited to noncash expenditures.

Question 56

When compared to the straight-line depreciation method, MACRS has:

A) a greater proportion of its depreciation early in the life of the asset.
B) a lesser proportion of its depreciation early in the life of the asset.
C) an equal proportion of its depreciation early in the life of the asset.
D) None of the above.

Question 57

The proper time to harvest an asset is when:

A) the percentage NPV increase of harvesting a project at a future point in time is at the last date where the increase is greater than the cost of capital.
B) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is less than the cost of capital.
C) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is greater than the cost of capital.
D) None of the above.

Question 58

The impact of a project on a firm's overall value depends on

A) a firm's accounting earnings.
B) a firm's cash flow.
C) a project's cash flow.
D) None of the above.

Question 59

Stillwater Drinks is trying to determine when to harvest the water from the fountain of youth that it currently owns. If it harvests the water in year 1, the NPV of the project would increase over an immediate harvest by 18 percent. A year 2 harvest would create an NPV increase of 12 percent over that of year 1 and year 3 would create an NPV increase of 8 percent over that of year 2. If the cost of capital is 17 percent for Stillwater, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.
B) Harvest in year 1.
C) Harvest in year 2.
D) Harvest in year 3.

Question 60

If the real return on U.S. Treasury bills is 14 percent while the rate of expected inflation is 8 percent, then what should nominal rate of return be? (Round final percentage answer to decimal places.)

A) 14.05%
B) 33.05%
C) 23.12%
D) None of the above.

Question 61

When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor? Assume the cost of capital for Nemo is 10 percent.

A) $3,000, do not purchase the new tractor
B) $3,209, purchase the new tractor
C) $4,000, purchase the new tractor
D) $12,163, purchase the new tractor

Question 62

When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent.

A) $2,352, do not purchase the oven
B) $6,000, purchase the oven
C) $9,668, purchase the oven
D) $24,668, purchase the new oven

Question 63

Projects with different lives: Your firm is deciding whether to purchase a high-quality printer for your office or one of lesser quality. The high-quality printer costs $40,000 and should last four years. The lesser quality printer costs $30,000 and should last three years. If the cost of capital for the firm is 13 percent, then what is the equivalent annual cost for the best choice for the firm? Round to the nearest dollar.

A) $10,000, either printer
B) $10,000, lesser quality printer
C) $12,706, lesser quality printer
D) $13,448, high-quality printer

Question 64

The cost of using an existing asset: Small Appliances, Inc., is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital.

A) $11,917
B) $12,500
C) $15,433
D) $50,000

Question 65

Explain why in practice the cash flows associated with a project are not certain cash flows.

Question 66

Projects with different lives: Your firm is deciding whether to purchase a durable delivery vehicle or a short-term vehicle. The durable vehicle costs $25,000 and should last five years. The short-term vehicle costs $10,000 and should last two years. If the cost of capital for the firm is 15 percent, then what is the equivalent annual cost for the best choice for the firm? (Round final answer to nearest whole dollar.)

A) $5,000, either vehicle
B) $5,000, short-term vehicle
C) $6,151, short-term vehicle
D) $7,458, long-term vehicle

Question 67

Briefly explain the two methods of comparing projects with different useful lives.

Question 68

Ref 11-2
Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.
Free cash flow: What is Provo's cash flows associated with investments for 2008?

A) $300,000
B) $500,000
C) $800,000
D) None of the above.

Question 69

Ref 11-2
Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.
Free cash flow: What is Champagne's cash flow from operations for 2008?

A) $2,050,000
B) $2,500,000
C) $3,250,000
D) $4,000,000

Question 70

Ref 11-1
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.
Reference: Ref 11-1
Free cash flow: What is Provo's cash flow from operations for 2008?

A) $2,400,000
B) $2,600,000
C) $3,400,000
D) $4,000,000

Question 71

Ref 11-2
Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.
Free cash flow: What is Champagne's free cash flow for 2008?

A) $2,050,000
B) $2,500,000
C) $3,250,000
D) $4,000,000

Question 72

Ref 11-1
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.
Reference: Ref 11-1
Norman, Inc., is considering two mutually exclusive projects. Project A is a six-year project with a NPV of $3,000 and Project B is a four-year project with an NPV of $2,278. Project A has an equivalent annual cash flow of $730 and Project B has an equivalent annual cash flow of $750. Which project should the firm select?

A) Choose Project A because it has the higher NPV.
B) Choose Project B because it has the lower NPV.
C) Choose Project B because it has the higher equivalent annual cash flow.
D) Choose Project A because it has the lower equivalent annual cash flow.

Question 73

Ref 11-1
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.
Reference: Ref 11-1
Free cash flow: What is Provo's NOPAT for 2008?

A) $2,400,000
B) $2,600,000
C) $3,400,000
D) $4,000,000

Question 74

Free cash flow: What are Champagne's cash flows associated with investments for 2008?

A) $500,000
B) $700,000
C) $1,200,000
D) None of the above.

Question 75

Ref 11-1
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.
Reference: Ref 11-1
Free cash flow: What is Provo's free cash flow for 2008?

A) $2,400,000
B) $2,600,000
C) $3,400,000
D) $4,000,000

Question 76

Computing the terminal-year FCF: Babaloo Nightclubs purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 39 percent marginal tax rate?

A) $500
B) $3,705
C) $4,205
D) $9,500

Question 77

Expected cash flows: FireRock Wheel Corp is evaluating a project in which there is a 40 percent probability of revenues totaling $3 million and a 60 percent probability of revenues totaling $1 million per year. Its cash expenses will be $1.0 million while depreciation expense will be $200,000; then what is the expected free cash flow from taking the project if the marginal tax rate for the firm is 30 percent?

A) $200,000
B) $420,000
C) $600,000
D) $620,000

Question 78

When to harvest an asset: Farmer Ag owns a special species of cotton-producing plant that, if left unharvested, grows a bigger bowl of cotton through time. The NPV, at the beginning of the year that harvesting takes place, is as follows. When should Farmer Ag harvest its cotton? Assume a discount rate of 14 percent. NPV₁ = $50,000
NPV₂ = $60,000
NPV₃ = $69,000
NPV₄ = $77,280
NPV₅ = $85,008

A) Harvest now
B) Harvest in year 1
C) Harvest in year 2
D) Harvest in year 3

Question 79

Computing the terminal-year FCF: Miles Cyprus Corp. purchased a truck that currently has a book value of $1,000. If the firm sells the truck for $5,000 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 30 percent marginal tax rate?

A) $1,200
B) $3,800
C) $4,000
D) $5,000

Question 80

Ref 11-2
Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.
Free cash flow: What is Champagne's NOPAT for 2008?

A) $1,750,000
B) $2,500,000
C) $3,250,000
D) $4,000,000