Question 1

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

Accepted Answer

MACRS depreciation method generally results in higher depreciation expense during the earlier years compared to straight-line depreciation, resulting in a higher present value of the depreciation tax shield. Option A is incorrect because the present value of the depreciation tax shield may vary depending on the depreciation method used. Option C is incorrect because the length of the recovery period does not necessarily determine the present value of the depreciation tax shield. Option D is incorrect because inflation may affect the value of the depreciation tax shield, but it does not necessarily increase it annually.

Question 2

At a 13% cost of capital,a project's NPV is $100,000 if you invest today.By what amount must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant.

Accepted Answer

Required decrease = $100,000 × (1.13)² − $100,000 = $27,690

Question 3

Methods of accelerated depreciation:

Accepted Answer

Methods of accelerated depreciation allow assets to be depreciated more rapidly, which means that more depreciation expenses are recognized in the earlier years of an asset's life. This, in turn, increases the depreciation tax shield, reducing taxable income and therefore reducing the tax liability.

Question 4

The opportunity cost of a resource should be considered in project analysis,unless:

Accepted Answer

The opportunity cost of a resource refers to the cost of foregone opportunities i.e. the value of the next best alternative forgone when a resource is used for a particular purpose. However, if a resource has no identifiable market value or alternative use within the firm, then it may not have any opportunity cost associated with its use. Therefore, option D is the correct answer. Option A is incorrect because negative cash flows do not necessarily mean that the opportunity cost should not be considered. Option B is incorrect because the fact that a resource was purchased in a prior time period does not necessarily mean that its opportunity cost should not be considered. Option C is incorrect because the fact that a resource has been fully depreciated does not necessarily mean that its opportunity cost should not be considered.

Question 5

A new inventory system will immediately reduce inventory levels by $100,000.If this reduction is permanent and the cost of capital is 13%,how does the net working capital change affect company value?

Accepted Answer

The reduction in inventory levels by $100,000 is a permanent reduction in net working capital, which directly increases the company's value by the same amount.

Question 6

What is the undiscounted cash flow in the final year of an investment,assuming $10,000 after-tax cash flows from operations,$1,000 from the sale of a fully depreciated machine,a $2,000 investment in working capital,and a 35% tax rate?

Accepted Answer

Cash flow_Final = $10,000 + $2,000 + $1,000 × (1 − 0.35) = $12,650

Question 7

Why is accelerated depreciation often favored for the corporation's set of tax books?

Accepted Answer

Accelerated depreciation allows a company to write off more of an asset's cost in the early years of its life, leading to earlier tax savings and improved cash flow.

Question 8

Which one of the following statements regarding depreciation is correct?

Accepted Answer

Tax law allows for accelerated depreciation to be used for tax purposes, which means that companies can take larger depreciation deductions in the earlier years of an asset's life. This can provide a larger tax shield in the earlier years, reducing taxable income and resulting in lower tax payments. MACRS (Modified Accelerated Cost Recovery System) is a specific method of accelerated depreciation that is used for tax purposes. Option A is incorrect because the depreciation tax shield doesn't adjust annually with inflation. Option B is incorrect because the real amount of annual depreciation can be affected by the rate of inflation, but the depreciation tax shield is based on the amount of depreciation claimed for tax purposes. Option D is incorrect because MACRS is specifically designed for tax purposes.

Question 9

Which of the following correctly adjusts for depreciation when calculating a project's operating cash flow?

Accepted Answer

Option A correctly adjusts for depreciation by adding back the tax shield from depreciation (tax rate × depreciation) to the operating cash flow calculation. This recognizes the fact that depreciation is a non-cash expense that reduces taxable income and results in a tax savings.

Question 10

An investment today of $25,000 promises to return $10,000 annually for the next 3 years.What is the real rate of return on this investment if inflation averages 6% annually during the period?

Accepted Answer

Using a financial calculator:n = 3, PV = −$25,000, PMT = $10,000, FV = $0, CPT i/Y = 9.701%Real return = 1.09701 / 1.06 − 1 = 0.0349, or 3.49%

Question 11

Under the MACRS:

Accepted Answer

Under the MACRS, assets are assumed to be purchased and sold midyear, which affects the depreciation calculation. Choices A, B, and C are incorrect because not all assets are depreciated over 5 years, depreciable percentages do not necessarily decline throughout the asset's class life, and straight-line depreciation percentages are not doubled under MACRS.

Question 12

When a depreciable asset is ultimately sold,the sales price is:

Accepted Answer

The sales price of a depreciable asset is taxable to the extent that it exceeds the asset's book value (the remaining undepreciated cost). This is because the full amount of depreciation taken throughout the life of the asset reduces the original cost (basis) of the asset, so when it is sold, only the portion of the sales price that exceeds the remaining undepreciated cost is considered a gain and therefore taxable.

Question 13

If inflation is forecast to increase,which of the company's following cash flows is most likely to change?

Accepted Answer

Labor costs are likely to increase in response to inflation, as wages and salaries tend to rise with increases in the cost of living. The other options are less likely to be directly affected by inflation forecasts; the depreciation tax shield depends on the firm's accounting policies, the costs of raw materials on fixed price contracts are typically locked in regardless of inflation, and interest payments on long-term debt are typically fixed or subject to contractual adjustments that may not depend on changes in inflation forecasts.

Question 14

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

Accepted Answer

The real rate of interest is the nominal rate minus the inflation rate. If the real rate is less than the nominal rate, it indicates that inflation is positive.

Question 15

The modified accelerated cost recovery system (MACRS)allows an increase:

Accepted Answer

MACRS allows for a higher amount of depreciation to be taken in the earlier years of an asset's life, which can result in significant tax savings during those years. This is achieved through assigning the asset to a specific asset class and using a set of depreciation rates and methods to calculate the annual depreciation expense. However, the total depreciation over the asset's life remains the same. The depreciable cost basis is also not increased, as it is based on the original purchase price of the asset. Real and nominal depreciation expenses are not relevant in this context.

Question 16

The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to:

Accepted Answer

The statement suggests that the decision to continue with the project is being based on the amount of resources already invested in it, rather than on the potential for future profits. This is an example of the sunk cost fallacy, where past costs that cannot be recovered are given too much weight in decision-making. Recognizing sunk costs would allow for a more rational evaluation of the project's profitability going forward.

Question 17

A project costs $12,800 and is expected to provide a real cash inflow of $10,000 at the end of each of years 1 through 5.Calculate the net present value of this project if inflation is expected to be 4% in each year and the firm employs a nominal discount rate of 10.76%.

Accepted Answer

Real rate = 1.1076 / 1.04 − 1 = 0.065NPV = −$12,800 + $10,000{(1 / 0.065) − [1 / 0.065(1.065)⁵]} = $28,756.79

Question 18

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

Accepted Answer

The increase in current assets and current liabilities of $125,000 each cancel each other out, resulting in no overall impact on net working capital investment. Therefore, the answer is (A) an increase of zero.

Question 19

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

Accepted Answer

Overhead costs may represent shared expenses that are not directly attributable to a specific project. Therefore, allocating these costs to projects may not accurately represent an incremental expense and may lead to incorrect project evaluation.

Question 20

A firm plans to purchase a $50,000 asset that will be depreciated straight-line over a 5-year life to a zero salvage value.What is the present value of the resulting depreciation tax shield if the tax rate is 35% and the discount rate is 10%?

Accepted Answer

Annual depreciation tax shield = $50,000 / 5 × 0.35 = $3,500PV of tax shield = $3,500 {(1 / 0.1) − [1 / 0.1(1.1)⁵]} = $13,267.75

Quiz 9: Using Discounted Cash-Flow Analysis to Make Investment Decisions