Deck 8: Net Present Value and Capital Budgeting

Question 1

Changes in the net working capital:

A) can affect the cash flows of a project every year of the project's life.
B) only affect the initial cash flows of a project.
C) are included in project analysis only if they represent cash outflows.
D) are generally excluded from project analysis due to their irrelevance to the total project.
E) affect the initial and the final cash flows of a project but not the cash flows of the middle years.

Answer 1

can affect the cash flows of a project every year of the project's life.

Question 2

One of the key differences between corporate finance and financial accounting courses is:

A) the focus on cash flows instead of earnings.
B) the focus on marginal tax rates versus average tax rates.
C) the role of total income flow versus incremental flows.
D) the focus on corporate avarice versus stewardship.

Answer 2

the focus on cash flows instead of earnings.

Question 3

Bluedo's has sales of $435,000, depreciation of $35,000, and net working capital of $56,000. The firm has a tax rate of 34% and a profit margin of 8%. The firm has no interest expense. What is the amount of the operating cash flow?

A) $46,068
B) $57,968
C) $69,800
D) $322,100
E) $114,340

Answer 3

$69,800

Question 4

Interest expense is typically excluded in the project cash flow because:

A) all projects are always financed only by equity.
B) taxes cannot be adjusted for the correct debt rate.
C) the discount rate or WACC reflects the cost of debt.
D) the analysis is too crude to handle debt impacts.

Question 5

A firm purchases a new truck for $30,000. It will be depreciated over 5 years at $6,000 per year. If the tax rate is 30% what is the time 0 cash flow?

A) -$6,000
B) -$21,000
C) -$30,000
D) -$28,200

Question 6

A decrease in a firm's current cash flows resulting from the implementation of a new project is referred to as:

A) salvage value expense.
B) net working capital expense.
C) sunk cost.
D) opportunity cost.
E) erosion cost.

Question 7

A project will produce an operating cash flow of $7,300 a year for three years. The initial cash investment in the project will be $11,600. The net after-tax salvage value is estimated at $3,500 and will be received during the last year of the project's life. What is the net present value of the project if the required rate of return is 11%?

A) $8,798.29
B) $9,896.87
C) $10,072.72
D) $13,353.41
E) $20,398.29

Question 8

A reduction in the sales of an existing product caused by the introduction of a new product is an example of a(n):

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

Question 9

The QT Company is generating cash flow of $333,000 per year. If they invest in a new press they expect to increase their cash flow to $400,000 per year. The cash outflow for the new press is $250,000; to accept or reject the investment they have to consider:

A) the press cost of $250,000 and total cash flow of $400,000.
B) the change in cash flow of $67,000 versus the price cost of $250,000.
C) the current cash flow of $333,000 and the price cost of $250,000.
D) the opportunity cost of the facility of $333,000.

Question 10

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

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

Question 11

The cash flow in dollars received in year 3 is expected to be $12,372. The firm uses a real discount rate of 4% and the inflation rate is expected to be 2.5%. What is the present value of the year 3 cash flow?

A) $10,213.35
B) $12,372.00
C) $9,777.77
D) $9,105.23
E) $13,285.83

Question 12

What is the inflation rate given a nominal interest rate is 13% when the real rate is 6%?

A) 19.00%
B) 6.60%
C) 7.00%
D) 19.78%

Question 13

The value of a previously purchased building used by a proposed project is an example of a(n):

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

Question 14

You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.

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

Question 15

A cost that has already been paid, or the liability to pay has already been incurred, is a(n):

A) salvage value expense.
B) net working capital expense.
C) sunk cost.
D) opportunity cost.
E) erosion cost.

Question 16

Sales for year 2 of the new project are expected to increase by 10%. Current assets are expected to increase by 17% for every dollar increase in sales while accounts payable are expected to increase by 6%. For year 2 the change in cash flows due to working capital will be:

A) +10% of sales.
B) -10% of sales.
C) +1.1% of sales.
D) -1.1% of sales.

Question 17

Peter's Boats has sales of $760,000 and a profit margin of 5%. The annual depreciation expense is $80,000. What is the amount of the operating cash flow if the company has no long-term debt?

A) $34,000
B) $86,400
C) $118,000
D) $120,400
E) $123,900

Question 18

What is the nominal rate of interest given a real rate of interest of 5% and an inflation rate of 7%?

A) 12.00%
B) 2.00%
C) 12.35%
D) 1.90%

Question 19

The cash flow in dollars received in year 3 is expected to be $12,372. The firm uses a real discount rate of 4% and the inflation rate is expected to be 2.5%. What is the real cash flow for year 3?

A) $13,916.82
B) $11,488.63
C) $10,998.66
D) $10,242.15
E) $14,944.75

Question 20

Le Place has sales of $439,000, depreciation of $32,000, and net working capital of $56,000. The firm has a tax rate of 34% and a profit margin of 6%. The firm has no interest expense. What is the amount of the operating cash flow?

A) $49,384
B) $52,616
C) $54,980
D) $58,340
E) $114,340

Question 21

RoadRollers Paving Company is considering buying a new asphalt laying machine. The machine costs $1,300,000 and can be depreciated to zero on a straight-line basis over its life of 10 years. The machine is expected to have no salvage value. Revenues are expected to be $600,000 per year, and cost are estimated at $220,000 per year. Operating cash flows are expected to rise with inflation, forecasted at 4% per year. The risk free rate of interest is 2% and the real interest rate is 4.0%, and given the expected inflation rate, the nominal rate is 8.16%. The firm is in the 34% tax bracket. Should the investment be undertaken?
A._04,10 = $1,955,974.73
Depreciation tax shield = (8.1109) ($130,000) (.34) = $358,501.78
NPV = $2,314,476.51 - 1,300,000 = $1,014,476.51); Accept.

Question 22

The incremental cash flow from projects for a company is computed as the:

A) net operating cash flow generated by the project, less any sunk costs and erosion costs.
B) sum of the incremental operating cash flow and after-tax salvage value of the project.
C) net income generated by the project, plus the annual depreciation expense.
D) sum of the incremental operating cash flow, capital spending, and change in net working capital of the project.
E) sum of the sunk costs, opportunity costs, and erosion costs of the project.

Question 23

If the inflation rate was positive the expected NPV of an investment would be:

A) understated if real cash flows were discounted by the nominal discount rate.
B) understated if nominal cash flows were discounted by the nominal discount rate.
C) overstated if the real cash flows were discounted by the nominal discount rate.
D) understated if the nominal cash flows were discounted by the real discount rate.
E) overstated if the real cash flows are discounted by the real discount rate.

Question 24

Ronnie's Coffee House is considering a project which will produce sales of $6,000 and increase cash expenses by $2,500. If the project is implemented, taxes will increase by $1,300. The additional depreciation expense will be $1,000. An initial cash outlay of $2,000 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?

A) $2,000
B) $1,500
C) $2,200
D) $3,500
E) $4,200

Question 25

A machine lasts 3 years and has a purchase price of $100. It costs $40 per year to operate and can be sold as junk for $15 at the end of its life. What is the EAC of the costs of operating a series of such machines into perpetuity if the discount rate is 15%?
A._15,3 -15/(1.15)³ = $181.47
The machine's equivalent annual cost is: $181.47/2.283 = $79.48

Question 26

Milton Toy Co. recorded sales of $2,500 and costs of $1,875. Net accounts receivable rose by $350 and net accounts payable declined by $240. What were cash sales minus cash costs?

A) $625
B) $35
C) ($110)
D) $90

Question 27

Tax shield refers to a reduction in taxes created by:

A) a reduction in sales.
B) an decrease in interest expense.
C) non-cash expenses.
D) a project's incremental expenses.
E) opportunity costs.

Question 28

Cash revenues in a particular year are equal to sales less:

A) the change in capital investment.
B) the change in accounts payable.
C) the change in NWC.
D) the change in accounts receivable.

Question 29

The bottom-up approach to computing the operating cash flow applies only when:

A) both the depreciation expense and the interest expense are equal to zero.
B) the interest expense is equal to zero.
C) the project is a cost-cutting project.
D) no fixed assets are required for the project.
E) taxes are ignored and the interest expense is equal to zero.

Question 30

Marshall's & Co. purchased a corner lot in Montreal five years ago at a cost of $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?

A) $1,200,000
B) $1,840,000
C) $1,890,000
D) $2,010,000
E) $2,060,000

Question 31

Which of the following is not a relevant item to consider in cash flow estimation?

A) A change in current assets invested in the project.
B) A change in current liabilities to finance new inventories.
C) Regular meeting fees for the board of directors incurred when the go-no go decision is made.
D) Any net changes in working capital over the life of the investment.

Question 32

The top-down approach to computing the operating cash flow:

A) ignores all non-cash items.
B) applies only if a project produces sales.
C) can only be used if the entire cash flows of a firm are included.
D) is equal to sales-costs-taxes + depreciation.
E) includes the interest expense related to a project.

Question 33

A project's operating cash flow will increase when:

A) the depreciation expense increases.
B) the sales projections are lowered.
C) the interest expense is lowered.
D) the net working capital requirement increases.
E) the earnings before interest and taxes decreases.

Question 34

You are considering whether to replace an existing flow meter. The existing meter can be sold now for $50 or it can be sold in 1 year for $10. It costs $30 per year to operate and maintain. A new meter costs $400 and has a 10-year life. It could be sold for $40 at the end of its life. The new meter costs $14 per year to operate and maintain. What do you recommend if the cost of capital is 12%?
A._12,10 - $40/(1.12)¹⁰ = $471.87; $4
71.87/5.65 = $83.51
Because the cost of keeping the old machine is less than the cost of the new machine, the old machine should not be replaced.

Question 35

The equivalent annual cost method is useful in determining:

A) the annual operating cost of a machine if the annual maintenance is performed versus when the maintenance is not performed as recommended.
B) the tax shield benefits of depreciation given the purchase of new assets for a project.
C) which one of two machines to acquire given equal machine lives but unequal machine costs.
D) which one of two machines to purchase when the machines are mutually exclusive, have different machine lives, and will be replaced once they are worn out.

Question 36

The cash flow tax savings generated as a result of a firm's tax-deductible depreciation expense is called the:

A) after-tax depreciation savings.
B) depreciable basis.
C) depreciation tax shield.
D) operating cash flow.
E) after-tax salvage value.

Question 37

Recently, you calculated the cashflows for the Highfeed Dryer project to determine the feasibility of a new feed mix process. Since that time you have now discovered that the calculation of the standard cash flow for Year 1 of $55,000 did not consider the following anticipated changes: account receivable are expected to increase $7,000; cash will rise by $2,000; inventory will increase by $4,000; and account payable are expected to increase $5,000. Determine the new estimated cashflow for Year 1.

Question 38

You have been asked to evaluate an infinitely-lived project. Sales in the first year are projected to be $100. Costs are projected at $50. There is no depreciation, and the tax rate is 30%. The real required return is 10%. The inflation rate is projected to be 8%. Sales and costs will increase at the rate of inflation. The project costs $300. What is the NPV?

A) $142.03
B) $36.36
C) $71.72
D) $50.00

Question 39

You have been asked to evaluate 2 pollution control devices. The wet scrub costs $100 to set up and $50 per year to operate. It must be completely replaced every 3 years, and it has no salvage value. The dry scrub device costs $200 to set up and $30 per year to operate. It lasts for 5 years and has no salvage value. Assuming that pollution control equipment is replaced as it wears out, which device do you recommend if the cost of capital is 10%?

A) Dry scrub, the EAC is $11.00.
B) Wet scrub, the EAC is $90.21.
C) Dry scrub, the EAC is $82.76.
D) Wet scrub, the EAC is $9.79.
E) Dry scrub, the EAC is $124.34.

Question 40

Ben's Border Café is considering a project which will produce sales of $16,000 and increase cash expenses by $10,000. If the project is implemented, taxes will increase from $23,000 to $24,500 and depreciation will increase from $4,000 to $5,500. What is the amount of the operating cash flow using the top-down approach?

A) $4,000
B) $4,500
C) $6,000
D) $7,500
E) $8,500

Question 41

Your boss just turned back your capital budgeting report because she is unsure of your results. The yearly revenues are going up at a constant rate equal to the consumer price index of 4% and the discount used was 6%. The boss also mentions that the long term Treasury bond rate is only 71/2%. Explain the boss' dilemma and how it should be corrected.

Question 42

The Equivalent Annual Cost method allows comparison of the costs of equipment with unequal lives. If Quick-roll machine has an eleven year life, and an NPV of $2,100, while the Zip-roller machine has a seven year life and an NPV of $2,000. Which machine would you choose if the business is expected to continue and the discount rate for both is 14%?

Question 43

When is it appropriate to use the equivalent annual cost (EAC) methodology, and how do you make a decision using it?

Question 44

This chapter introduced three new methods for calculating project operating cash flow (OCF). Under what circumstances is each method appropriate?

Question 45

The Expresso Roast Corporation is considering the purchase of a new bean roaster and grinder. The revenues are expected to be the same for Expresso Roast no matter which machine is acquired. The Quick-Roast machine has a cost of $75,000 and is expected to last 4 years with operating costs of $12,000 per year. The Mellow-Roast Co. machine has a cost of $50,000 and operating costs of $4,500 per year but will last for only 2 years. The discount rate is 8%. What is the present value of the costs? What is the EAC and which machine should be chosen?

Question 46

Bruno's, Inc. is analyzing two machines to determine which one it should purchase. The company requires a 14% rate of return and uses straight-line depreciation to a zero book value. Machine A has a cost of $290,000, annual operating costs of $8,000, and a 3-year life. Machine B costs $180,000, has annual operating costs of $12,000, and has a 2-year life. Whichever machine is purchased will be replaced at the end of its useful life. Which machine should Bruno's purchase and why? (Round your answer to whole dollars.)

Question 47

Jackson & Sons uses packing machines to prepare its products for shipping. One machine costs $136,000 and lasts about 4 years before it needs replaced. The operating cost per machine is $6,000 a year. What is the equivalent annual cost of one packing machine if the required rate of return is 12%? (Round your answer to whole dollars.)

Question 48

You are considering replacing your current dado cutter with a new machine. The current machine is expected to last three more years but faces increasing repair costs of $2,500; $3,500; and $4,000 over the three years. You could salvage the machine now for $5,000; and then $3,000; $1,500; and 0 thereafter. The new dado cutter would cost $12,000 and require upkeep of $1,500 a year. The machine would last six years and be salvaged for $1,000. Should you replace the old machine now or wait one year? (Assume the tax rate is 0% and the cost of capital is 11%).