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Question 1:

2D1-LS02

Which of the following items is not an example of a capital expenditure?


A ventilation system upgrade for EPA compliance.
Project bonuses paid to employees.
Purchase of a new assembly machine that will cut labor and maintenance costs.
Purchase of a new computer server for the research and development group.

Long-term capital budget expenditures are often grouped in one of the following categories:
new machines and equipment intended for expansion, replacement of existing equipment,
some allocations for research and development for new products and/or the expansion of
existing products, mandatory projects required by law for safety, and other long-term
exploratory expenditures for buildings, land, patents, and so on.
Question 2:
2D1-LS10

Which of the following is a primary difference between a cash outflow related to the
development of a new product and the expenditure made for the bulk purchase of raw
materials for existing products?
Potential profitability.
Contribution to working capital.
The number of accounting periods.
Effect of inflation.

Development of a new product exemplifies a capital investment; the bulk purchase of raw
materials is a current investment. A capital budgeting project spans more than one accounting
period whereas current investments can be written often in the same period in which the
expenses occur.
Question 3:
2D1-AT05

Which one of the following is most relevant to a manufacturing equipment replacement


decision?
disposal price of the old equipment.
original cost less depreciation of the old equipment.
a lump-sum write-off amount from the disposal of the old equipment.
gain or loss on the disposal of the old equipment.

Relevant costs and revenues include cash flows caused by the decision. The disposal price of
the old equipment is a cash inflow that decreases the initial investment required for the
replacement decision.

Question 4:
2D1-AT03

In order to increase production capacity, Gunning Industries is considering replacing an


existing production machine with a new technologically improved machine effective January 1.
The following information is being considered by Gunning Industries.
The new machine would be purchased for $160,000 in cash. Shipping, installation,
and testing would cost an additional $30,000.
The new machine is expected to increase annual sales by 20,000 units at a sales
price of $40 per unit. Incremental operating costs are comprised of $30 per unit in
variable costs and total fixed costs of $40,000 per year.
The investment in the new machine will require an immediate increase in working
capital of $35,000.
Gunning uses straight-line depreciation for financial reporting and tax reporting
purposes. The new machine has an estimated useful life of five years and zero
salvage value.
Gunning is subject to a 40% corporate income tax rate.

Gunning uses the net present value method to analyze investments and will employ the
following factors and rates.

Gunning Industries' initial net cash outflow in a capital budgeting decision would be:
$195,000.
$225,000.
$160,000.
$190,000.

Gunning's initial cash outflow at time zero is calculated as follows:

Initial cash outflow = (initial cost of new machine) + (shipping, installation, and testing related
to the new machine) + additional working capital required
Initial cash outflow = $160,000 + $30,000 + $35,000 = $225,000.
Question 5:
2D1-LS13

All of the following are methods used to evaluate investments for capital budgeting
decisions except:
*Source: Retired ICMA CMA Exam Questions.

required rate of return.


accounting rate of return.
excess present value (profitability) index.
internal rate of return.

All of the following are methods used to evaluate investments for capital budgeting:
accounting rate of return, internal rate of return, excess present value (profitability) index. The
required rate of return is used as the discount rate for present value calculations or as the
hurdle rate for accounting or internal rates of return.
Question 6:
2D1-AT06

In equipment-replacement decisions, which one of the following does not affect the decisionmaking process?
cost of the new equipment.
operating costs of the new equipment.
operating costs of the old equipment.
original fair market value of the old equipment.

The original fair market value of the old equipment is a sunk cost. Sunk costs are costs that
have already occurred and cannot be recovered in the future. Therefore, they are irrelevant
for decision making.
Question 7:
2D1-AT07

The management of Pelican Inc. is evaluating a proposed acquisition of a new machine at a


purchase price of $180,000. A $9,000 increase in working capital will be required. The
machine will have a useful life of four years after which it will have no salvage value. The
estimated annual incremental operating revenues and cash operating expenses are $450,000
and $300,000, respectively, for each of the four years. Pelican's effective income tax rate is
40% and the cost of capital is 12%. Pelican uses straight-line depreciation for both financial
reporting and income tax purposes.

If the project is accepted, the estimated incremental after-tax operating cash flows at the end
of the first year will be:
$150,000.
$108,000.
$99,000.
$105,000.

Year 1 cash flows:

Question 8:
2D1-AT11

All of the following capital budgeting analysis techniques use cash flows as the primary basis
for the calculation except for the:
accounting rate of return (ARR).
internal rate of return.
payback period.
net present value.

The ARR method of evaluating potential investments selects an investment based upon its
ARR. The ARR is calculated by dividing the average annual net income of a project by its
average investment. Net income is an accrual, not a cash concept.
Question 9:
2D1-AT08

Mobile Home Manufacturing Inc. is evaluating a proposed acquisition of a new machine at a


purchase price of $380,000 and installation charges that will amount to $20,000. A $15,000
increase in working capital will be required. The machine will have a useful life of four years
after which it can be sold for $50,000. The estimated annual incremental operating revenues
and cash operating expenses are $750,000 and $500,000, respectively, for each of the four
years. Mobile Home's tax rate is 40% and the cost of capital is 12%. Mobile Home uses

straight-line depreciation for both financial reporting and income tax purposes.
If Mobile Home accepts the project, the initial investment will be:
$350,000.
$415,000.
$365,000.
$385,000.

Initial investment will include the purchase price, installation cost, and increase in working
capital. Thus, initial investment = $380,000 + $20,000 + $15,000 = $415,000.
Question 10:
2D1-AT14

Maxgo Company is considering replacing its current computer system. The new system would
cost Maxgo $60,000 to have it installed and operational. It would have an expected useful life
of four years and an estimated salvage value of $12,000. The system would be depreciated
on a straight-line basis for financial statement reporting purposes and use an accelerated
depreciation method for income tax reporting purposes. Assume that the percentages of
depreciation for tax purposes are 25%, 40%, 20%, and 15% for the four-year life of the new
computer.
Maxgo's current computer system has been fully depreciated for both financial statement and
income tax reporting purposes. It could be used for four more years but not as effectively as
the new computer system. The old system currently has an estimated salvage value of $8,000
and will have an estimated salvage value of $1,000 in four years. It is estimated that the new
system will save $15,000 per year in operating costs. Also, because of features of the new
software, working capital could immediately be reduced by $3,000 if the new system is
purchased. Maxgo expects to have an effective income tax rate of 30% for the next four
years.
Assuming that Maxgo Company purchases the new system, what will be the estimated net
cash flow from operations for the first year of using the new system?
$10,500.
$23,000.
$20,600.
$15,000.

The net cash flow in the first year of operation is calculated by taking the after-tax net income
from the project and adding the first year depreciation on the system to that amount.

The after-tax net income = [the annual savings of $15,000 depreciation of $15,000 (0.25
$60,000 MACRS)] = $0.
The net cash flow = $0 + $15,000 depreciation in year 1 = $15,000.
Question 11:
2D1-AT12

As used in capital budgeting analysis, the internal rate of return (IRR) uses which of the
following items in its computation?
net incremental investment-yes; incremental average operating income-no; net annual cash flowsyes.
net incremental investment-yes; incremental average operating income-yes; net annual cash flowsyes.
net incremental investment-no; incremental average operating income-yes; net annual cash flowsyes.
net incremental investment-yes; incremental average operating income-yes; net annual cash flowsno.

The IRR is the discount rate used in the calculation of net present value (NPV) that causes
the NPV to equal zero. NPV = Present value (PV) of the project's annual cash flows
(calculated at the appropriate discount rate less the project's net incremental investment).
Question 12:
2D1-LS04

Determining incremental cash flows for a capital investment project requires all of the
following except:
examining both revenues and expenses for the accounting period.
including sunk costs.
including opportunity costs.
taking into account the anticipated effects of inflation.

Sunk costs are historical and irrelevant because they have no effect on future cash flows.
Question 13:
2D1-LS11

Capital investment projects include proposals for all of the following except:
*Source: Retired ICMA CMA Exam Questions.

refinancing existing working capital agreements.


additional research and development facilities.
the acquisition of government mandated pollution control equipment.

the expansion of existing product offerings.

Capital investment projects include many possibilities; including proposals for the acquisition
of equipment, the expansion of existing product offerings, and additional research and
development facilities. Refinancing is not a capital budgeting decision. It is a financing
decision.
Question 14:
2D1-LS03

As related to relevant cash flow categories, direct effect refers to the:


total outflows to fund an investment and initiate a project.
net increase or decrease in tax depreciation charges.
immediate effect that a cash inflow, outflow, or commitment has on cash flows.
change in a firm's taxpaying obligations.

By definition, direct effect refers to the immediate effect that a cash inflow, outflow, or
commitment has on cash flows.
Question 15:
2D1-LS16

In discounted cash flow techniques, which one of the following alternatives best reflects the
items to be incorporated, in the initial net cash investment?

*Source: Retired ICMA CMA Exam Questions.

Yes

No

No

No

No

Yes

No

No

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

In discounted cash flow techniques, many items should incorporated in the initial net cash
investment; some items that can be included are capitalized expenditures, changes in net
working capital, proceeds from the sale of assets, and changes in liabilities. The initial net
cash investment is the net cash flow at the inception of the project (time 0).
Question 16:
2D1-AT15

Maxgo Company is considering replacing its current computer system. The new system would
cost Maxgo $60,000 to have it installed and operational. It would have an expected useful life
of four years and an estimated salvage value of $12,000. The system would be depreciated

on a straight-line basis for financial statement reporting purposes and use an accelerated
depreciation method for income tax reporting purposes. Assume that the percentages of
depreciation for tax purposes are 25%, 40%, 20%, and 15% for the four-year life of the new
computer.
Maxgo's current computer system has been fully depreciated for both financial statement and
income tax reporting purposes. It could be used for four more years but not as effectively as
the new computer system. The old system currently has an estimated salvage value of $8,000
and will have an estimated salvage value of $1,000 in four years. It is estimated that the new
system will save $15,000 per year in operating costs. Also, because of features of the new
software, working capital could immediately be reduced by $3,000 if the new system is
purchased. Maxgo expects to have an effective income tax rate of 30% for the next four
years.
For Maxgo Company, determine the net incremental investment (i.e., net cash outflow at time
0) if the new computer system is purchased.
$51,400.
$52,000.
$57,000.
$49,000.

The net incremental investment for the project consists of the net cash flows occurring at the
beginning of the project. The net cash outflow at the beginning of the project is calculated as:
Net cash flow = system installed cost old system salvage value + tax on salvage value of old
system reduction in working capital from the project
Net cash flow = ($60,000) ($8,000) + [($8,000 old system salvage value $0 book value)
(0.30 tax rate)] ($3,000)
Net cash flow = $51,400.
Question 17:
2D1-AT09

A company is considering the purchase of a new machine to replace a five-year-old machine


and has gathered the following information.

If the company replaces the old machine with the new machine, what is the cash flow in
period 0?
($51,200).
($49,000).
($51,800).
($53,000).

Cost and installation, cash outflow = $50,000 + $4,000 = $54,000


Sale of old machine, cash inflow = $5,000
Tax effect of sale of old machine, cash outflow = ($5,000 $2,000) 0.40 = $1,200
Increase in net working capital, cash outflow = $1,000
Total cash outlay = Inflows outflows = $5,000 ($54,000 + $1,200 + $1,000) = ($51,200).
Question 18:
2D1-LS09

All of the following incremental cash flows would be examined during the project termination
phase of a capital investment project for new equipment except:
increase or decrease in net working capital.
salvage value of any sold or disposed assets.
net increase or decrease in taxes related to the asset disposal.
additional capitalized expenditures.

Additional capitalized expenditures (e.g., shipping and installation charges) would be


examined during project initiation. The other activities are cash flows specifically associated
with project termination.
Question 19:
2D1-AT10

Which one of the following is the best characteristic concerning the capital budget? The
capital budget is a(n):
exercise that sets the long-range goals of the company including the consideration of external
influences caused by others in the market.
plan to ensure that there are sufficient funds available for the operating needs of the company.
plan that results in the cash requirements during the operating cycle.
plan that assesses the long-term needs of the company for plant and equipment purchases.

A capital budget is a long-term budget of investments in property, plant, and equipment and of
the future cash inflows and outflows related to the investments.
Question 20:

2D1-LS08

Which of the following approaches compares high-yield investments and allows values to be
plotted on a frequency distribution graph?
Linear programming.
Sensitivity analysis.
Regression analysis.
Simulations.

Simulations can be used to compare multiple risky investments. The net present value (NPV)
or the internal rate of return (IRR) for each project can be simulated several times and
averaged. NPVs, IRRs, and standard deviations can be computed and ranked. Repetition
allows values to be plotted on a frequency distribution graph to show the distribution and
provides a reasonable assessment about the risk level of a project.
Question 21:
2D1-LS15

In estimating "after-tax incremental cash flows," under discounted cash flow analyses for
capital project evaluations, which one of the following options reflects the items that should be
included in the analyses?
*Source: Retired ICMA CMA Exam Questions.

Sunk Costs: No; Change in Net Working Capital: Yes; Estimated Impacts of Inflation: Yes.
Sunk Costs: No; Change in Net Working Capital: No; Estimated Impacts of Inflation: Yes
Sunk Costs: No; Change in Net Working Capital: Yes; Estimated Impacts of Inflation: No.
Sunk Costs: Yes; Change in Net Working Capital: No; Estimated Impacts of Inflation: No.

In estimating "after-tax incremental cash flows," under discounted cash flow analyses for
capital project evaluations, project related changes in net working capital and estimated
impacts of inflation should be included in the analysis. Sunk costs are past costs that do not
change as a result of a future decision and should not be included in the analysis.
Question 22:
2D1-AT04

In order to increase production capacity, Gunning Industries is considering replacing an


existing production machine with a new technologically improved machine effective January 1.
The following information is being considered by Gunning Industries.
The new machine would be purchased for $160,000 in cash. Shipping, installation,
and testing would cost an additional $30,000.
The new machine is expected to increase annual sales by 20,000 units at a sales
price of $40 per unit. Incremental operating costs are comprised of $30 per unit in
variable costs and total fixed costs of $40,000 per year.

The investment in the new machine will require an immediate increase in working
capital of $35,000.
Gunning uses straight-line depreciation for financial reporting and tax reporting
purposes. The new machine has an estimated useful life of five years and zero
salvage value.
Gunning is subject to a 40% corporate income tax rate.

Gunning uses the net present value method to analyze investments and will employ the
following factors and rates.

Gunning Industries' discounted annual depreciation tax shield for the first year of operation
would be:
$22,800.
$13,817.
$15,200.
$20,725.

The depreciation tax shield for a period is calculated by taking the depreciation for the period
and multiplying it by the relevant tax rate. Using straight-line depreciation, the annual
depreciation charge is calculated as:
Annual depreciation charge, straight-line depreciation = (depreciable base) / (estimated
service life)
For Gunning, the depreciable base will include the initial cost of the machine and the shipping,
installation and testing. Therefore, the depreciable base will be calculated as follows:
Depreciable base = $160,000 + $30,000 = $190,000
Annual depreciation charge, straight-line depreciation = ($160,000 + $30,000) / (5 years)

Annual depreciation charge, straight-line depreciation = $190,000 / 5 years = $38,000


The annual depreciation tax shield is calculated by taking the annual depreciation and
multiplying it by the tax rate, as follows:
Annual depreciation tax shield = (annual depreciation)(tax rate)
Annual depreciation tax shield = ($38,000)(0.40) = $15,200
The discounted annual depreciation tax shield is calculated by taking the annual depreciation
tax shield and discounting it by the appropriate present value of $1 factor, as follows:
Discounted annual depreciation tax shield = (annual depreciation tax shield)(present value of
$1 factor)
The present value of $1 factor for 10% at the end of year 1 is 0.909.
Discounted annual depreciation tax shield = ($15,200)(0.909) = $13,817.
Question 23:
2D1-LS06

All of the following incremental cash flows would be examined during the operation phase of a
capital investment project except:
net proceeds from the sale of old assets.
net increase or decrease in taxes.
net increase or decrease in operating expenses (excluding depreciation).
net increase or decrease in operating revenue.

Net proceeds from the sale of old assets would be examined during project initiation.
Following the initial cash outflows necessary to begin a project, a firm hopes to benefit from
the other cash flows generated during subsequent periods.
Question 24:
2D1-LS01

Capital budgeting is best described as:


the process of making long-term investment decisions.
decision making related to current expenditures.
the process of planning for short-term investments.
decision making to support operating efficiency.

By definition, capital budgeting is the process of making long-term investment decisions. It is a


decision-making process that enables a firm to evaluate the viability of a long-term project and
whether it is worth undertaking.
Question 25:
2D1-AT02

At the beginning of the fiscal year, Barclays Inc. had equipment with a book value of $160,000
and $64,000 in accumulated depreciation. During the year, equipment costing $30,000 with a
book value of $1,000 was sold for $7,000. The ending balance of the equipment book value
account equaled $220,000 and accumulated depreciation at the end of the fiscal year was
$80,000.
The total amount of equipment purchased during the fiscal year is:
$44,000.
$97,000.
$60,000.
$106,000.

Beginning equipment balance

$224,000

Less: Equipment sold

($30,000)

Add: Purchased equipment

Ending equipment balance

$300,000

Equipment purchases = Ending equipment balance cost - Beginning equipment balance cost
+ Equipment sold = $300,000 - $224,000 + $30,000 = $106,000
Question 26:
2D1-LS12

Which one of the following items is least likely to directly impact an equipment replacement
capital expenditure decision?
*Source: Retired ICMA CMA Exam Questions.

The amount of additional accounts receivable that will be generated from increased production and
sales.
The net present value (NPV) of the equipment that is being replaced.
The depreciation rate that will be used for tax purposes on the new asset.
The sales value of the asset that is being replaced.

The NPV of the equipment that is being replaced is a sunk cost and would not be considered
in the decision to replace the equipment.
Question 27:
2D1-LS07

A manufacturer of small appliances buys a new injection molding machine. The firm must also
pay shipping and installation charges. All of the following statements are true regarding the
depreciation amount allowable except:

Shipping and installation charges are included as part of the depreciable basis.
Shipping and installation charges are expensed during the period in which they are incurred.
Tax credits may reduce the amount allowable below the original cost.
Tax laws may allow depreciation amounts in excess of the investment.

Typically, the depreciable amount allowable is the original cost of the asset. This includes
other capitalized expenditures that are necessary to prepare the asset for use (such as
shipping and installation charges). In some situations, the amount allowable can be greater or
less than the original investment costs due to tax credits and tax laws, respectively.
Question 28:
2D1-AT01

In order to increase production capacity, Gunning Industries is considering replacing an


existing production machine with a new technologically improved machine effective January 1.
The following information is being considered by Gunning Industries.
The new machine would be purchased for $160,000 in cash. Shipping, installation,
and testing would cost an additional $30,000.
The new machine is expected to increase annual sales by 20,000 units at a sales
price of $40 per unit. Incremental operating costs are comprised of $30 per unit in
variable costs and total fixed costs of $40,000 per year.
The investment in the new machine will require an immediate increase in working
capital of $35,000.
Gunning uses straight-line depreciation for financial reporting and tax reporting
purposes. The new machine has an estimated useful life of five years and zero
salvage value.
Gunning is subject to a 40% corporate income tax rate.

Gunning uses the net present value method to analyze investments and will employ the
following factors and rates.

The overall discounted cash flow impact of Gunning Industries' working capital investment for
the new production machine would be:
$(35,000).
$(13,265).
$21,735.
$13,265.

The overall discounted cash flow impact of Gunning Industries' working capital investment for
the new production machine is calculated by taking the discounted working capital reversal at
the end of the project (at time = 5), and subtracting the original working capital investment at
the beginning of the project's life (or, at time = 0).
The discounted working capital reversal at the end of the project is calculated as:
Discounted working capital at end of project = (initial working capital requirement)(factor for
present value of $1, at 10%, for five periods)
Discounted working capital at end of project = ($35,000)(0.621) = $21,735
The working capital requirement at time = 0 would not be discounted, since it is occurring now,
and not at some point in the future. So, the overall discounted cash flow impact of Gunning
Industries' working capital investment for the new production machine would be:
Discounted overall working capital requirement = (working capital requirement at time=5)
(working capital requirement at time = 0)
Discounted overall working capital requirement = $21,735 $35,000 = $13,265, or
$(13,265).
Question 29:
2D1-AT13

Maxgo Company is considering replacing its current computer system. The new system would
cost Maxgo $60,000 to have it installed and operational. It would have an expected useful life
of four years and an estimated salvage value of $12,000. The system would be depreciated
on a straight-line basis for financial statement reporting purposes and use an accelerated
depreciation method for income tax reporting purposes. Assume that the percentages of
depreciation for tax purposes are 25%, 40%, 20%, and 15% for the four-year life of the new
computer.
Maxgo's current computer system has been fully depreciated for both financial statement and
income tax reporting purposes. It could be used for four more years but not as effectively as
the new computer system. The old system currently has an estimated salvage value of $8,000
and will have an estimated salvage value of $1,000 in four years. It is estimated that the new
system will save $15,000 per year in operating costs. Also, because of features of the new

software, working capital could immediately be reduced by $3,000 if the new system is
purchased. Maxgo expects to have an effective income tax rate of 30% for the next four
years.
Assuming that Maxgo Company purchases the new system, determine the estimated net cash
flow for the fourth (last) year of using the new system.
$20,900.
$21,600.
$18,600.
$17,900.

The net cash flow in the fourth year of operation is calculated by taking the after-tax net
income from the project, and adding the fourth year's depreciation on the system (adjusted for
the after-tax salvage value of the new system less the foregone salvage on the old system
and the increase in working capital requirements).
The after-tax net income = pretax income income tax = $6,000 - $1,800 = $4,200
Where the pre-tax income = annual savings depreciation = $15,000 $9,000 = $6,000,
the depreciation = 0.15 $60,000 MACRS = $9,000, and
the income tax = 0.30 $6,000 = $1,800.
Net salvage value = New system foregone salvage on the old system = $12,000 $1,000 =
$11,000.
Tax on the net salvage is an outflow of $3,300 (0.30 $11,000 (the new system's book value
at the end of year four is zero))
The increase in working capital (the reversal) is an outflow of $3,000.
Therefore, the net cash flow in year four = After-tax net income + Depreciation + Net salvage
Tax on the salvage - Increase in working capital
= $4,200 + $9,000 + $11,000 $3,300 $3,000 = $17,900.
Note that depreciation is added back since it is not a cash flow and the change in NWC is
used as it is assumed to occur at the end of the last year for the system's budget.
Question 30:
2D1-LS14

Cora Lewis is performing an analysis to determine if her firm should invest in new equipment
to produce a product recently developed by her firm. The other option would be to abandon
the product. She uses the net present value (NPV) method and discounts at the firm's cost of
capital. Lewis is contemplating how to handle the following items.

I. The book value of warehouse space currently used by another division.


II. Interest payments on debt to finance the equipment.
III. Increased levels of accounts payable and inventory.
IV. R&D spent in prior years and treated as a deferred asset for book and tax purposes.
Which of the above items are relevant for Lewis to consider in determining the cash flows for
her NPV calculation?
*Source: Retired ICMA CMA Exam Questions.

I, II, III and IV.


IV only.
II and III only.
III only.

Increased levels of accounts payable and inventory are relevant costs that should be included
in the NPV calculation for this situation. II (interest payments on debt used to finance the
equipment) is a financing concern used in determining the discount rate. I (the book value of
the warehouse space currently used by another division) and IV (R&D spent in prior years and
treated as a deferred asset for book and tax purposes) are sunk, irrelevant costs.
Question 1:
2D1-LS05

For a firm evaluating different capital budget proposals, what is the first stage of the capital
budgeting process?
Identify which type of capital budget expenditures are necessary.
Develop capital budgets.
Assess how the projects will affect the organization's resources and whether the firm can absorb the
costs.
Review historical results from other capital projects.

A capital budgeting project consists of a logical progression of activities. The first stage in
capital budgeting is to identify which type of capital budget expenditures are necessary and in
line with organizational strategies, objectives, and goals.