Question 1

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?

Accepted Answer

The answer of Brown Mack, Inc., currently has two large...

Question 2

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.)

Accepted Answer

The real rate of return is calculated by subtracting the inflation rate from the nominal rate. 
Real rate of return = Nominal rate - Inflation rate 
= 20% - 10% 
= 10% 
However, this needs to be adjusted for compounding, which results in the following calculation: 
Real rate of return = (1 + Nominal rate) / (1 + Inflation rate) - 1 
= (1 + 0.20) / (1 + 0.10) - 1 
= 0.0909 or 9.09% 
Therefore, the accurate real rate of return on these securities is 9.09%.

Question 3

The proper time to harvest an asset is when:

Accepted Answer

The proper time to harvest an asset is when 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. This ensures that the asset is kept as long as it generates returns above the cost of capital, maximizing the investment's value.

Question 4

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. If the firm takes that project, then it will 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?

Accepted Answer

Free cash flow can be calculated as follows:

Revenue: $12 million
Cash expenses: -$5 million
Depreciation: -$1 million
Taxable income: $6 million ($12 million - $5 million - $1 million)
Taxes at 40%: -$2.4 million ($6 million x 0.4)
Net income: $3.6 million ($6 million - $2.4 million)
Subtract the revenue lost from existing project: -$2 million
Free cash flow: $1.6 million ($3.6 million - $2 million)

Therefore, the free cash flow on the project, per year, if the firm is in the 40% marginal tax rate is $3.4 million (Option B).

Question 5

If you are deciding whether to take one project or another, where the projects have different useful lives, then you could utilize:

Accepted Answer

Both repeated investment analysis and equivalent annual annuity analysis can be used to compare projects with different useful lives by standardizing their cash flows over a common period.

Question 6

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.

Accepted Answer

To determine the harvest year that maximizes NPV, we need to calculate the discounted cash flows for each year and choose the option with the highest NPV.

Let's assume that the immediate harvest generates a cash flow of $100. Then, the cash flows for the other options can be calculated as follows:

Year 1 harvest: $125 (25% increase) 
Year 2 harvest: $143.75 ((125*1.15) - 100) 
Year 3 harvest: $153.84 ((143.75*1.07) - 125)

Now we can calculate the NPV of each option using the formula:

NPV = CF / (1+r)^t

where r is the cost of capital (12%) and t is the time period (in years).

Immediate harvest: 
NPV = 100 / (1+0.12)^0 = $100

Year 1 harvest: 
NPV = 125 / (1+0.12)^1 = $111.61

Year 2 harvest: 
NPV = 143.75 / (1+0.12)^2 = $109.51

Year 3 harvest: 
NPV = 153.84 / (1+0.12)^3 = $109.28

Therefore, the option with the highest NPV is harvesting in year 2 with an NPV of $109.51.

Question 7

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

Accepted Answer

The answer of For a U.S. corporation with income above...

Question 8

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

Accepted Answer

A sunk cost is a past cost that has already been incurred and cannot be recovered. Historical research and development costs fit this definition because they have already been spent and their recovery is not possible. Future payments on a leased building and future research and development costs are not sunk costs because they are still avoidable and can be recovered by making different decisions. Historical noncash expenses are not sunk costs because they do not involve actual cash outlays.

Question 9

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.

Accepted Answer

The NPV increases by 18% in year 1, which is greater than the cost of capital (17%). However, the subsequent increases in years 2 and 3 (12% and 8%, respectively) are less than the cost of capital. Therefore, harvesting in year 1 maximizes the NPV since the increase in NPV from waiting exceeds the cost of capital only in the first year.

Question 10

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

Accepted Answer

MACRS frontloads the depreciation, which means that a greater proportion of the depreciation is taken early in the life of the asset compared to the straight-line depreciation method.

Question 11

Free cash flow: What is Provo's cash flow from operations for 2008?

Accepted Answer

Cash flow from operations can be calculated as follows: Start with revenues ($10 million) then subtract cash operating expenses ($5 million) and taxes. Taxes are calculated on the operating income, which is revenues minus operating expenses and depreciation ($10M - $5M - $1M = $4M). The tax on the operating income is 40% of $4 million, which is $1.6 million. So, the cash flow from operations is $10M - $5M - $1.6M = $3.4 million.

Question 12

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

Accepted Answer

The nominal rate of return can be calculated using the Fisher equation:

Nominal rate = Real rate + Expected inflation

Substituting the given values, we get:

Nominal rate = 14% + 8% = 22%

Therefore, the nominal rate of return should be 22%, which is closest to choice C (23.12%).

Question 13

If a firm has the option of leasing some factory space to another firm or utilizing it for another product line, then if the firm chose the product line how should it handle the lost lease payments on the factory space?

Accepted Answer

The lost lease payments represent an opportunity cost for the firm. Therefore, including it as an opportunity cost would be the most appropriate way to handle it in the decision-making process. Ignoring it or including it as additional revenue for the project would not accurately reflect the true cost of the decision.

Question 14

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

Accepted Answer

The negative impact on existing project's cash flows should be included as a negative revenue amount on the new project's cash flow analysis, as it directly affects the cash flows of the new project. Ignoring it could lead to incorrect project evaluation and decision-making. This is true regardless of the cost of capital used and whether the impact is on cash or noncash expenditures.

Question 15

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

Accepted Answer

Allocated expenses, also known as non-cash expenses, should not be included in a project's cash flow calculations as they do not result in actual cash outflows. Only cash expenses and cash revenues have a direct impact on a project's cash flow.

Question 16

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

Accepted Answer

A progressive tax system is one in which taxpayers pay a higher percentage of their income in taxes as their income level increases. The opposite of a progressive tax system is a flat tax system, in which all taxpayers pay the same percentage of their income in taxes regardless of income level. A digressive tax system, on the other hand, is one in which the tax rate decreases as income level increases, which is not commonly used in practice. A political tax system is not a commonly recognized term for a particular type of tax system.

Question 17

_____________ represent dollars stated in terms of constant purchasing power.

Accepted Answer

Real dollars represent dollars adjusted for inflation, so that their purchasing power remains constant over time. Nominal dollars are the actual dollar amount stated without any adjustment for inflation, while inflated dollars refer to dollars that have lost purchasing power due to inflation.

Question 18

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

Accepted Answer

When discounting cash flows using the nominal cost of capital, both the real rate of return and the expected rate of inflation are considered, as the nominal rate includes both components.

Question 19

In order for a project to generate a positive net working capital cash flow at the conclusion of a project,

Accepted Answer

The answer of In order for a project to generate...

Question 20

Corporate overhead allocations should only be taken into account on project analysis if:

Accepted Answer

Corporate overhead allocations are not relevant to project analysis as they do not involve cash expenditures and do not affect the cash flows of the project. Therefore, they should not be taken into account in project analysis regardless of whether the firm is able to cover them or not.

Quiz 11: Cash Flows and Capital Budgeting