Corporate Finance, 2e, Global Edition (Berk/DeMarzo) the project.

Chapter 7 Fundamentals of Capital Budgeting

5) Which of the following statements is false? (M)
7.1 Forecasting Earnings A) Because value is lost when a resource is used by another project, we should include the
1) Which of the following statements is false? (E) opportunity cost as an incremental cost of the project.
A) A capital budget lists the projects and investments that a company plans to undertake during the B) Sunk costs are incremental with respect to the current decision regarding the project and should
coming year. be included in its analysis.
B) Income Tax = EBIT × (1 - τc). C) Overhead expenses are associated with activities that are not directly attributable to a single
C) When sales of a new product displace sales of an existing product, the situation is often referred business activity but instead affect many different areas of the corporation.
to as cannibalization. D) When computing the incremental earnings of an investment decision, we should include all
D) Overhead expenses are often allocated to the different business activities for accounting changes between the firm's earnings with the project versus without the project.
purposes.
6) Which of the following statements is false? (M)
2) Which of the following statements is false? (E) A) The firm deducts a fraction of the investments in plant, property, and equipment each year as
A) Sales will ultimately decline as the product nears obsolescence or faces increased competition. depreciation.
B) Managers sometimes continue to invest in a project that has a negative NPV because they have B) If securities are fairly priced, the net present value of a fixed set of cash flows is independent of
already invested a large amount in the project and feel that by not continuing it, the prior how those cash flows are financed.
investment will wasted. C) Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in
C) With straight-line depreciation the asset's cost is divided equally over its life. capital budgeting analysis.
D) A projects unlevered net income is equal to its incremental revenues less costs and D) A good rule to remember is that if our decision does not affect a cash flow then the cash flow
depreciation, evaluated on an pre-tax basis. should not affect our decision.

3) Which of the following statements is false?(E) 7) Which of the following statements is false? (M)
A) We begin the capital budgeting process by determining the incremental earnings of a project. A) The ultimate goal in capital budgeting is to determine the effect of the decision to take a
B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre- particular project on the firm's cash flows.
tax income. B) To the extent that overhead costs are fixed and will be incurred in any case, they are
C) Investments in plant, property, and equipment are directly listed as expense when calculating incremental to the project and should be included in the capital budgeting analysis.
earnings. C) Unlevered Net Income = (Revenue - Costs - Depreciation) × (1 - τc).
D) The opportunity cost of using a resource is the value it could have provided in its best D) Earnings are not cash flows.
alternative use.
8) Which of the following statements is false? (D)
4) Which of the following statements is false? (M) A) Project externalities are direct effects of the project that may increase of decrease the profits of
A) When evaluating a capital budgeting decision, the correct tax rate to use is the firm's average other business activities of the firm.
corporate tax rate. B) Incremental earnings are the amount by which the firm's earnings are expected to change as a
B) To determine the capital budget, firms analyze alternative projects and decide which ones to result of the investment decision.
accept through a process called capital budgeting. C) The average selling price of a product and its cost of production will generally change over time.
C) A new product typically has lower sales initially, as customers gradually become aware of the D) Any money that has already been spent is a sunk cost and therefore irrelevant in the capital
product. budgeting process.
D) Sunk costs have been or will be paid regardless of the decision whether or not to proceed with
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9) Which of the following statements is false? (M)
A) Many projects use a resource that the company already owns.
B) When evaluating a capital budgeting decision, we generally include interest expense.
C) Only include as incremental expenses in your capital budgeting analysis the additional overhead
expenses that arise because of the decision to take on the project.
D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often
begin by forecasting earnings.
D) a sunk cost.
Use the information for the question(s) below.
Ford Motor Company is considering launching a new line of Plug-in Electric SUVs. The heavy
advertising expenses associated with the new SUV launch would generate operating losses of $35
million next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from
operations next year. Ford pays a 30% tax rate on its pre-tax income.

10) Which of the following statements is false? (E) 15) The amount that Ford Motor Company owe in taxes next year without the launch of the new
A) The simplest method used to calculate depreciation is the straight-line method. SUV is closest to: (E)
B) A sunk cost is any unrecoverable cost for which the firm is already liable. A) $24.0 million
C) Unlevered Net Income = EBIT × τc. B) $56.0 million
D) The decision to continue or abandon should be based only on the incremental costs and C) $31.5 million
benefits of the project going forward. D) $13.5 million
Explanation: A) = $80 × .30 = $24 million
11) Which of the following costs would you consider when making a capital budgeting decision? (E)
A) Sunk cost 16) The amount that Ford Motor Company owe in taxes next year with the launch of the new SUV
B) Opportunity cost is closest to: (E)
C) Interest expense A) $13.5 million
D) Fixed overhead cost B) $31.5 million
C) $56.0 million
12) A decrease in the sales of a current project because of the launching of a new project is (E) D) $24.0 million
A) cannibalization. Explanation: A) = (80 - 35) × .30 = 13.5 million
B) a sunk cost.
C) an overhead expense. Use the information for the question(s) below.
D) irrelevant to the investment decision. Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their
store. The firm expects that sales from the new one hour machine will be $150,000 per year. FFL
13) Money that has been or will be paid regardless of the decision whether or not to proceed with currently offers overnight film processing with annual sales of $100,000. While many of the one
the project is (E) hour photo sales will be to new customers, FFL estimates that 60% of their current overnight photo
A) cannibalization. customers will switch and use the one hour service.
B) considered as part of the initial investment in the project.
C) an opportunity cost. 17) The level of incremental sales associated with introducing the new one hour photo service is
D) a sunk cost. closest to: (M)
A) $90,000
14) The value of currently unused warehouse space that will be used as part of a new capital B) $150,000
budgeting project is (E) C) $60,000
A) an opportunity cost. D) $120,000
B) irrelevant to the investment decision. Explanation: A) = $150,000 - (cannibalized sales) = 150000 - .60 × 100,000 = $90,000
C) an overhead expense.
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18) Suppose that of the 60% of FFL's current overnight photo customers, half would start taking Strip sales = 100,000 × ($100 - $25) = $7,500,000
their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour
service. The level of incremental sales in this case is closest to: (M) Total EBIT = 7,900,000 + 7,500,000 = 15,400,000
A) $60,000
B) $150,000 With Price Cut
C) $90,000 Monitor sales = 130,000 × ($99 - $50) = $6,370.000
D) $120,000 Strip sales = 130,000 × ($100 - $25) = $9,750,000
Explanation: D) = $150,000 - (cannibalized sales) = 150000 - (.60 × .50) × 100,000 = $120,000
Note that the rate of cannibalization is only 30% (.60 × .50) since the other 30% would have taken Total EBIT = 6,370,000 + 9,750,000 = 16,120,000
their film elsewhere.
Incremental = 16,120,000 - 15,400,000 = 720,000
Use the information for the question(s) below.
Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000, to Use the information for the question(s) below.
diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The cost of The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has
goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the next an estimated life of three years. The cost of the machine is $30,000 and the machine will be
year. depreciated straight line over its three-year life to a residual value of $0.

19) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated
over the next year by 30% to 130,000 units. The incremental impact of this price drop on the firms to grow by 10% per year each year through year three. The price per cane that Sisyphean will
EBIT is closest to: (M) charge its customers is $18 each and is to remain constant. The canes have a cost per unit to
A) a decline of 1.5 million manufacture of $9 each.
B) an increase of 1.5 million
C) a decline of 2.4 million Installation of the machine and the resulting increase in manufacturing capacity will require an
D) an increase of 2.4 million increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
Explanation: A) Without price cut = 100,000 units × ($129 - 50) = $7,900,000 needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
With price cut = 130,000 units × ($99 - 50) = $6,370,000 its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the
So, incremental = 6,370,000 - 7,900,000 = -1,530,000 35% tax bracket, and has a cost of capital of 10%.

20) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales 21) The incremental EBIT in the first year for the Sisyphean Corporation's project is closest to: (D)
over the next year by 30% to 130,000 units. Also suppose that for each Glucoscan monitor sold, A) $18,000
GSI expects additional sales of $100 per year on glucose testing strips and these strips have a B) $8,000
gross profit margin of 75%. Considering the increase in the sale of testing strips, the incremental C) $11,700
impact of this price drop on the firms EBIT is closest to: (D) D) $5,200
A) A decline of 1.5 million Explanation: B)
B) A decline of 0.7 million Incremental Earnings Forecast
C) An increase of 0.7 million Year 1 2 3
D) An increase of 1.5 million Units 2,000 2,200 2,420
Explanation: C) Without Price Cut Sales (units × $18) 36,000 39,600 43,560
Monitor sales = 100,000 × ($129 - $50) = $7,900,000 Cost of Good Sold (units × $9) 18,000 19,800 21,780
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Gross Profit 18,000 19,800 21,780 Incremental Earnings Forecast
Depreciation ($30,000 / 3) 10,000 10,000 10,000 Year 1 2 3
EBIT 8,000 9,800 11,780 Units 2,000 2,200 2,420
Income tax at 35% 2,800 3,430 4,123 Sales (units × $18) 36,000 39,600 43,560
Unlevered net income 5,200 6,370 7,657 Cost of Good Sold (units × $9) 18,000 19,800 21,780
Gross Profit 18,000 19,800 21,780
22) The incremental unlevered net income in the first year for the Sisyphean Corporation's project Depreciation ($30,000 / 3) 10,000 10,000 10,000
is closest to: (D) EBIT 8,000 9,800 11,780
A) $8,000 Income tax at 35% 2,800 3,430 4,123
B) $18,000 Unlevered net income 5,200 6,370 7,657
C) $5,200
D) $11,700 25) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or
Explanation: C) why not? (M)
Incremental Earnings Forecast Answer: A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs will
Year 1 2 3 have to be paid regardless of the decision whether or not to proceed with the project. Therefore,
Units 2,000 2,200 2,420 sunk costs are not incremental with respect to the current decision regarding the project and
Sales (units × $18) 36,000 39,600 43,560 should not be included in its analysis.
Cost of Good Sold (units × $9) 18,000 19,800 21,780
Gross Profit 18,000 19,800 21,780 26) What is an opportunity cost? Should it be included in the incremental cash flows for a project?
Depreciation ($30,000 / 3) 10,000 10,000 10,000 Why or why not? (M)
EBIT 8,000 9,800 11,780 Answer: Many projects use resources that the company already owns. An opportunity cost is the
Income tax at 35% 2,800 3,430 4,123 cost of using a resource that otherwise could have provided value to the firm. The opportunity cost
Unlevered net income 5,200 6,370 7,657 of using a resource is the value it could have provided in its best alternative use. Because this
value is lost when a resource is used by another project, we should always include the opportunity
23) The depreciation tax shield for the Sisyphean Corporation's project in the first year is closest cost as an incremental cost of the project.
to: (M)
A) $8,000 Use the information for the question(s) below.
B) $3,500 The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has
C) $2,800 an estimated life of three years. The cost of the machine is $30,000 and the machine will be
D) $5,200 depreciated straight line over its three-year life to a residual value of $0.

24) The amount of incremental income taxes that the Sisyphean Company will pay in the first year The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated
on this new project is closest to: (M) to grow by 10% per year each year through year three. The price per cane that Sisyphean will
A) $6,300 charge its customers is $18 each and is to remain constant. The canes have a cost per unit to
B) $5,200 manufacture of $9 each.
C) $3,500
D) $2,800 Installation of the machine and the resulting increase in manufacturing capacity will require an
Explanation: D) increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
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its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the D) Firms often report a different depreciation expense for accounting and for tax purposes.
35% tax bracket, and has a cost of capital of 10%.
4) Which of the following statements is false? (E)
27) Construct a simple income statement showing the incremental EBIT and the incremental A) Most projects will require the firm to invest in net working capital.
unlevered net income for all three years of the Sisyphean Companies project. (D) B) The main components of net working capital are cash, inventory, receivables, and property,
Answer: plant and equipment.
Incremental Earnings Forecast C) ΔNWCt = NWCt - NWCt - 1.
Year 1 2 3 D) In the final year of a project, the firm ultimately recovers the investment in net working capital.
Units 2,000 2,200 2,420
Sales (units × $18) 36,000 39,600 43,560 5) Which of the following statements is false? (M)
Cost of Good Sold (units × $9) 18,000 19,800 21,780 A) Depreciation expenses have a positive impact on free cash flow.
Gross Profit 18,000 19,800 21,780 B) Free Cash Flow = (Revenues - Costs - Depreciation) × (1 - τc) - Capital Expenditures - ΔNWC +
Depreciation ($30,000 / 3) 10,000 10,000 10,000 τc × Depreciation.
EBIT 8,000 9,800 11,780 C) The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay
Income tax at 35% 2,800 3,430 4,123 dividends to shareholders.
Unlevered net income 5,200 6,370 7,657 D) The depreciation tax shield is the tax savings that results from the ability to deduct depreciation.

7.2 Determining Free Cash Flow and NPV 6) Which of the following statements is false? (M)
1) Which of the following statements is false? (M) A) Because only the tax consequences of depreciation are relevant for free cash flow, we should
A) Depreciation is not a cash expense paid by the firm. use the depreciation expense that the firm will use for tax purposed in our free cash flow forecasts.
B) Net Working Capital = Cash + Inventory + Payables - Receivables. B) A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into
C) Since 1997, companies can "carry back" losses for two years and "carry forward" losses for 20 based on its overall level of pre-tax income.
years. C) Free Cash Flow = (Revenues - Costs) × (1 - τc) - Capital Expenditures - ΔNWC + τc ×
D) Earnings do not represent real profits. Depreciation.
D) Net working capital is the difference between current liabilities and current assets.
2) Which of the following questions is false? (E)
A) Net Working Capital = Current Assets - Current Liabilities. 7) Which of the following statements is false? (M)
B) Because depreciation is not a cash flow, we do not include it in the cash flow forecast. A) The terminal of continuation value of the project represents the market value (as of the last
C) Tax loss carry backs allow corporations to take losses during the current year and use them to forecast period) of the free cash flow from the project at all future dates.
offset income in future years. B) The incremental effect of a project on the firm's available cash is the project's free cash flow.
D) Earnings are an accounting measure of firm performance. C) (1 - τc) × Depreciation is called the depreciation tax shield.
D) To evaluate a capital budgeting decision, we must determine its consequences for the firm's
3) Which of the following statements is false? (E)
available cash.
A) Depreciation is a method used for accounting and tax purposes to allocate the original purchase
cost of the asset over its life.
8) Which of the following cash flows are relevant incremental cash flows for a project that you are
B) Sometimes the firm explicitly forecast free cash flow over a shorter horizon than the full horizon
currently considering investing in? (M)
of the project or investment.
A) The tax savings brought about by the project's depreciation expense
C) Earnings include the cost of capital investments, but do not include non-cash charges, such as
B) The cost of a marketing survey you conducted to determine demand for the proposed project
depreciation.
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C) Interest payments on debt used to finance the project
D) Research and Development expenditures you have made
9) Your firm is considering building a new office complex. Your firm already owns land suitable for
the new complex. The current book value of the land is $100,000, however a commercial real
estate again has informed you that an outside buyer is interested in purchasing this land and would
be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring
taxes, the appropriate incremental cash flow for the use of this land is: (M)
A) $650,000
B) $0
C) $100,000
D) $750,000
Explanation: A) It is appropriate to use the market value. If taxes are include, the value would be
the after-tax value of the land.
expense of $2.5 million. If Sisyphean's marginal corporate tax rate is 40% and their average
corporate tax rate is 30%, then what is the value of the depreciation tax shield on their new
project? (M)
A) $750,000
B) $1,000,000
C) $1,500,000
D) $1,750,000
Explanation: B) Here we need to use the marginal tax rate.
So depreciation tax shield = $2,500,000 × .40 = $1 million
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has
an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.

10) You are considering adding a microbrewery on to one of your firm's existing restaurants. This The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated
will entail an increase in inventory of $8,000, an increase in Accounts payable of $2,500, and an to grow by 10% per year each year through year three. The price per cane that Sisyphean will
increase in property, plant, and equipment of $40,000. All other accounts will remain unchanged. charge its customers is $18 each and is to remain constant. The canes have a cost per unit to
The change in net working capital resulting from the addition of the microbrewery is: (E) manufacture of $9 each.
A) $45,500
B) $10,500 Installation of the machine and the resulting increase in manufacturing capacity will require an
C) $6,500 increase in various net working capital accounts. It is estimated that the Sisyphean Corporation
D) $5,500 needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
Explanation: D) NWC = CA - CL = $8000 - $2500 = $5500 its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the
35% tax bracket, and has a cost of capital of 10%.
11) You are considering adding a microbrewery on to one of your firm's existing restaurants. This
will entail an investment of $40,000 in new equipment. This equipment will be depreciated straight 13) The required net working capital in the first year for the Sisyphean Corporation's project is
line over five years. If your firm's marginal corporate tax rate is 35%, then what is the value of the closest to: (D)
microbrewery's depreciation tax shield in the first year of operation? (M) A) $3,600
A) $2,800 B) $3,960
B) $14,000 C) $2,880
C) $5,200 D) $5,400
D) $26,000 Explanation: A)
Explanation: A) First figure out the straight line depreciation. Networking Capital Forecast
Year 1 2 3
$40,000 / 5 years = $8000 depreciation per year. Units 2,000 2,200 2,420
Then .35 × $8000 = $2,800 depreciation tax shield per year. Sales (units × $18) 36,000 39,600 43,560
Cash (2% of sales) 720 792 871.2
12) The Sisyphean Company is considering a new project that will have an annual depreciation Accounts Receivable (4% of sales) 1440 1584 1742.4
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Inventory (9% of sales) 3240 3564 3920.4 The firm had depreciation expenses of $125 million and capital expenditures of $150 million.
Accounts Payable (5% of sales) 1800 1980 2178 Although they had no interest expense, the firm did have an increase in net working capital of $20
NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 million. What is Bubba Ho-Tep's free cash flow? (M)
A) $170 million
14) The required net working capital in the second year for the Sisyphean Corporation's project is B) $255 million
closest to: (D) C) $150 million
A) $3,960 D) $5 million
B) $4,360 Explanation: B) FCF = NI + Dep - Capital Ex - chg NWC
C) $3.190 = 300 + 125 - 150 - 20 = 255
D) $5,940
Explanation: A) Use the information for the question(s) below.
Networking Capital Forecast Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a
Year 1 2 3 temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in
Units 2,000 2,200 2,420 this facility to various agencies and groups providing relief services to the area. THSI estimates
Sales (units × $18) 36,000 39,600 43,560 that this project will initially cost $5 million to setup and will generate $20 million in revenues during
Cash (2% of sales) 720 792 871.2 its first and only year in operation (paid in one year). Operating expenses are expected to total $12
Accounts Receivable (4% of sales) 1440 1584 1742.4 million during this year and depreciation expense will be another $3 million. THSI will require no
Inventory (9% of sales) 3240 3564 3920.4 working capital for this investment. THSI's marginal tax rate is 35%.
Accounts Payable (5% of sales) 1800 1980 2178
17) Ignoring the original investment of $5 million, what is THSI's free cash flow for the first and only
NWC (Cash + Inventory+ AR - AP) 3600 3960 4356
year of operation? (M)
A) $5.0 million
15) The change in Net working capital from year one to year two is closest to: (D)
B) $3.75 million
A) A decrease of $360
C) $8.0 million
B) An increase of $360
D) $6.25 million
C) An increase of $396
Explanation: D) FCF = (revenues - expenses - depreciation) × (1 - tax rate) + depreciation
D) A decrease of $396
FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25
Explanation: B)
Networking Capital Forecast
18) Assume that THSI's cost of capital for this project is 15%. The NPV of this temporary housing
Year 1 2 3
project is closest to: (M)
Units 2,000 2,200 2,420 A) $435,000
Sales (units × $18) 36,000 39,600 43,560 B) -$650,000
Cash (2% of sales) 720 792 871.2 C) $1,960,000
Accounts Receivable (4% of sales) 1440 1584 1742.4 D) -$435,000
Inventory (9% of sales) 3240 3564 3920.4 Explanation: A) FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25
Accounts Payable (5% of sales) 1800 1980 2178 So, NPV = -5.0 + 6.25 / 1.15 = .434782 or $434,782
NWC (Cash + Inventory+ AR - AP) 3600 3960 4356
Use the information for the question(s) below.
16) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year. Shepard Industries is evaluating a proposal to expand its current distribution facilities.
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Management has projected the project will produce the following cash flows for the first two years Explanation: D) Revenues 1200 1400
(in millions). - Expenses 450 525
- Depreciation 240 280
Year 1 2 = EBIT 510 595
Revenues 1200 1400 - Taxes (30%) 153 178.5
Operating Expense 450 525 Incremental Net Income 357 416.5
Depreciation 240 280
Increase in working capital 60 70 22) The incremental unlevered net income Shepard Industries in year two is closest to: (M)
Capital expenditures 300 350 A) $355
Marginal corporate tax rate 30% 30% B) $415
C) $600
19) The incremental EBIT for Shepard Industries in year one is closest to: (M) D) $510
A) $360 Explanation: B)
B) $750 Revenues 1200 1400
C) $595 - Expenses 450 525
D) $510 - Depreciation 240 280
Explanation: D) = EBIT 510 595
Revenues 1200 1400 - Taxes (30%) 153 178.5
- Expenses 450 525 Incremental Net Income 357 416.5
- Depreciation 240 280
= EBIT 510 595 23) The depreciation tax shield for Shepard Industries project in year one is closest to: (E)
A) $84
20) The incremental EBIT for Shepard Industries in year two is closest to: (M) B) $168
A) $415 C) $96
B) $875 D) $72
C) $595 Explanation: D) $240 × .30 = $72
D) $510
Explanation: C) 24) The depreciation tax shield for Shepard Industries project in year two is closest to: (E)
Revenues 1200 1400 A) $84
- Expenses 450 525 B) $196
- Depreciation 240 280 C) $72
= EBIT 510 595 D) $96
Explanation: A) $280 × .30 = $84
21) The incremental unlevered net income Shepard Industries in year one is closest to: (M)
A) $510 25) The free cash flow from Shepard Industries project in year one is closest to: (M)
B) $415 A) $240
C) $600 B) $300
D) $355 C) -$5

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D) $390 Sales (Revenues) 100,000 100,000 100,000
Explanation: A) - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
Free Cash Flow - Depreciation 30,000 30,000 30,000
Revenues 1200 1400 = EBIT 20,000 20,000 20,000
- Expenses 450 525 - Taxes (35%) 7000 7000 7000
- Depreciation 240 280 = unlevered net income 13,000 13,000 13,000
= EBIT 510 595 + Depreciation 30,000 30,000 30,000
- Taxes (30%) 153 178.5 + changes to working capital -5,000 -5,000 10,000
Incremental Net Income 357 416.5 - capital expenditures -90,000
+ Depreciation 240 280
- Capital expenditures 300 350 27) The free cash flow for the first year of Epiphany's project is closest to: (M)
- Change in NWC 60 70 A) $43,000
Free Cash Flow 237 276.5 B) $25,000
C) $38,000
26) The free cash flow from Shepard Industries project in year two is closest to: (M) D) $45,000
A) $345 Explanation: C)
B) $455 Year 0 1 2 3
C) $275 Sales (Revenues) 100,000 100,000 100,000
D) -$5 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
Explanation: C) - Depreciation 30,000 30,000 30,000
Free Cash Flow = EBIT 20,000 20,000 20,000
Revenues 1200 1400 - Taxes (35%) 7000 7000 7000
- Expenses 450 525 = unlevered net income 13,000 13,000 13,000
- Depreciation 240 280 + Depreciation 30,000 30,000 30,000
= EBIT 510 595 + changes to working capital -5,000 -5,000 10,000
- Taxes (30%) 153 178.5 - capital expenditures -90,000
Incremental Net Income 357 416.5 = Free Cash Flow -90,000 38,000 38,000 53,000
+ Depreciation 240 280
- Capital expenditures 300 350 PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724
- Change in NWC 60 70 discount rate 0.12
Free Cash Flow 237 276.5 NPV = 11,946
IRR = 19.14%
Use the information for the question(s) below.
Epiphany Industries is considering a new capital budgeting project that will last for three years. 28) The free cash flow for the last year of Epiphany's project is closest to: (M)
Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive A) $53,000
research, it has prepared the following incremental cash flow projects: B) $38,000
C) $35,000
Year 0 1 2 3 D) $43,000
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Explanation: A) discount rate 0.12
Year 0 1 2 3 NPV = 11,946
Sales (Revenues) 100,000 100,000 100,000 IRR = 19.14%
- Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
- Depreciation 30,000 30,000 30,000 30) Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the
= EBIT 20,000 20,000 20,000 past four years. If Luther earns $15 million per year in pre-tax income from now on, Luther first
- Taxes (35%) 7000 7000 7000 pays taxes in: (E)
= unlevered net income 13,000 13,000 13,000 A) 7 years
+ Depreciation 30,000 30,000 30,000 B) 2 years
+ changes to working capital -5,000 -5,000 10,000 C) 4 years
- capital expenditures -90,000 D) 5 years
= Free Cash Flow -90,000 38,000 38,000 53,000 Explanation: D) The number of years the tax loss carryforwards will last ban be calculated as the
tax loss carry forward dividend by the annual pre-tax income or:
PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724 Years with no tax = = 4.67 years, so Luther won't have to pay taxes for the next
discount rate 0.12
NPV = 11,946 four years, but will have to start paying some taxes 5 years from now.
IRR = 19.14%
31) You are considering investing $600,000 in a new automated inventory system that will provide
29) The NPV for Epiphany's Project is closest to: (D) and after-tax cost savings of $50,000 next year. These cost savings are expected to grow at the
A) $4,825 same rate as sales. If sales are expected to grow at 5% per year and your cost of capital is 10%,
B) $39,000 then what is the NPV of the automated inventory system? (M)
C) $11,946 A) $400,000
D) $20,400 B) $500,000
Explanation: C) C) -$100,000
Year 0 1 2 3 D) $1,000,000
Sales (Revenues) 100,000 100,000 100,000 Explanation: A) NPV = - $600,000 = $400,000
- Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
- Depreciation 30,000 30,000 30,000
= EBIT 20,000 20,000 20,000 Use the information for the question(s) below.
- Taxes (35%) 7000 7000 7000 The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has
= unlevered net income 13,000 13,000 13,000 an estimated life of three years. The cost of the machine is $30,000 and the machine will be
+ Depreciation 30,000 30,000 30,000 depreciated straight line over its three-year life to a residual value of $0.
+ changes to working capital -5,000 -5,000 10,000
- capital expenditures -90,000 The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated
= Free Cash Flow -90,000 38,000 38,000 53,000 to grow by 10% per year each year through year three. The price per cane that Sisyphean will
charge its customers is $18 each and is to remain constant. The canes have a cost per unit to
manufacture of $9 each.
PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724
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Installation of the machine and the resulting increase in manufacturing capacity will require an sold will be 50% of sales. At the end of year three the machine will be sold for $15,000. The
increase in various net working capital accounts. It is estimated that the Sisyphean Corporation appropriate cost of capital is 10% and Kinston is in the 35% tax bracket.
needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of
its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 33) Assume that Kinston's new machine will be depreciated straight line to a salvage value of
35% tax bracket, and has a cost of capital of 10%. $5,000 at the end of year three. What is the after-tax salvage value of this project? (M)
Answer: If the machine is depreciated straight line to a book value of $5,000. So $15,000 - $5,000
32) Calculate the total Free Cash Flows for each of the three years for the Sisyphean Corporation's = $10,000 gain on the sale which is taxable. So the after tax salvage value = $15,000 - $10,000
new project. (D) × .35 (tax rate) = $11,500.
Answer:
Incremental Earnings Forecast 34) Assume that Kinston's new machine will be depreciated straight line to a salvage value of
Year 1 2 3 $5,000 at the end of year three. What is the NPV for this project? (D)
Units 2,000 2,200 2,420 Answer:
Sales (units × $18) 36,000 39,600 43,560 Year 0 1 2 3
Cost of Good Sold (units × $9) 18,000 19,800 21,780 Sales (revenues) 120,000 120,000 120,000
Gross Profit 18,000 19,800 21,780 Cost of Goods Sold 60,000 60,000 60,000
Depreciation ($30,000 / 3) 10,000 10,000 10,000 - Depreciation 40,000 40,000 40,000
EBIT 8,000 9,800 11,780 EBIT 20,000 20,000 20,000
Income tax at 35% 2,800 3,430 4,123 -Taxes(35%) 7,000 7,000 7,000
Unlevered net income 5,200 6,370 7,657 = unlevered net income 13,000 13,000 13,000
Add back Depreciation 10,000 10,000 10,000 + Depreciation 40,000 40,000 40,000
Cash Flows from Operations 15,200 16,370 17,657 + capital expenditures -125,000
+ Liquidation cash flows 11,500
Networking Capital Forecast Free Cash Flow -125,000 53,000 53,000 64,500
Year 1 2 3 PV of FCF (I = 10%) -125,000 48,182 43,802 48,46
Sales (units × $18) 36,000 39,600 43,560 NPV = 15,443
Cash (2% of sales) 720 792 871.2
Accounts Receivable (4% of sales) 1440 1584 1742.4 Liquidation/Salvage Value Calculation:
Inventory (9% of sales) 3240 3564 3920.4 If the machine is depreciated straight line to a book value of $5,000. So $15,000 - $5,000 =
Accounts Payable (5% of sales) 1800 1980 2178 $10,000 gain on the sale which is taxable. So, the after tax salvage value = $15,000 - $10,000
NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 × .35 (tax rate) = $11,500.
Change (investment) in NWC -3600 -360 -396 4356
35) Assume that Kinston's new machine will be depreciated using MACRS according to the
Investment in machine -30,000 following schedule:
Total Free Cash Flows -33,600 14,840 15,974 22,013
Year 3 Years
Use the information for the question(s) below. 1 33.33%
Kinston Industries is considering investing in a machine that will cost $125,000 and will last for 2 44.45%
three years. The machine will generate revenues of $120,000 each year and the cost of goods 3 14.81%
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4 7.41% 1) The incremental cash flow that Galt Motors will incur today (Year 0) if they elect to manufacture
armatures in house is closest to: (E)
What is the NPV of this project? (M) A) -740,000
Answer: B) -700,000
Year 0 1 2 3 C) -660,000
Sales (revenues) 120,000 120,000 120,000 D) 740,000
Cost of Goods Sold 60,000 60,000 60,000 Explanation: A) CF0 = -700,000 + - 40,000 = -740,000
- Depreciation 41,663 55,563 18,513
EBIT 18,338 4,438 41,488 2) The incremental cash flow that Galt Motors will incur in year 4 if they elect to manufacture
-Taxes(35%) 6,418 1,553 14,521 armatures in house is closest to: (E)
= unlevered net income 11,919 2,884 26,967 A) 25,000
+ Depreciation 41,663 55,563 18,513 B) 350,000
+ capital expenditures -125,000 C) 375,000
D) 1,250,000
+ Liquidation cash flows 12,992
Explanation: C) Incremental cash flow = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 =
374,500
Free Cash Flow -125,000 53,582 58,447 58,471
PV of FCF (I = 10%) -125,000 48,711 48,303 43,930 3) The incremental cash flow that Galt Motors will incur in year 10 if they elect to manufacture
NPV = 15,944 armatures in house is closest to: (M)
A) 40,000
Liquidation/Salvage Value Calculation: B) 335,000
C) 375,000
If the machine is depreciated straight line to a book value of 7.41% × 125,000 = $9,263. So D) 415,000
$15,000 - $9,263 = $5,737 gain on the sale which is taxable. So the after tax salvage value = Explanation: D) Incremental cash flow = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 +
$15,000 - $7,737 × .35 (tax rate) = $12,992. 40,000 = 414,500
7.3 Choosing Among Alternatives 4) The NPV for Galt Motors of manufacturing the armatures in house is closest to: (D)
Use the following information to answer the question(s) below. A) 1,095,000
Galt Motors currently produces 500,000 electric motors a year and expects output levels to remain B) 1,215,000
steady in the future. It buys armatures from an outside supplier at a price of $2.50 each. The plant C) 1,225,000
manager believes that it would be cheaper to make these armatures rather than buy them. Direct D) 1,250,000
in-house production costs are estimated to be only $1.80 per armature. The necessary machinery Explanation: C) CF0 = -700,000 + - 40,000 = -740,000
would cost $700,000 and would be obsolete in 10 years. This investment would be depreciated to CF(1 - 9) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 = 374,500
zero for tax purposes using a 10-year straight line depreciation. The plant manager estimates that CF(10) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 + 40,000 = 414,500
the operation would require additional working capital of $40,000 but argues that this sum can be CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute NPV = 1,224,225
ignored since it is recoverable at the end of the ten years. The expected proceeds from scrapping
the machinery after 10 years are estimated to be $10,000. Galt Motors pays tax at a rate of 35% 5) The IRR for Galt Motors of manufacturing the armatures in house is closest to: (D)
and has an opportunity cost of capital of 14%. A) 48%
B) 49%
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C) 50% A) 6,500
D) 53% B) 7,800
Explanation: C) CF0 = -700,000 + - 40,000 = -740,000 C) 10,800
CF(1 - 9) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 = 374,500 D) 11,500
CF(10) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 + 40,000 = 414,500 Explanation: D) Incremental EBITDA = 50,000 - 35,000 = 15,000
CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute IRR = 49.7639% Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000
Incremental cash flow = (15,000 - 5,000) x (1 - .35) + 5,000 = 11,500
6) What decision should Galt Motors take regarding manufacturing the armatures in house? (D)
A) Proceed with in house manufacture since NPV is negative 9) The incremental after tax cash flow that the Krusty Krab will receive from selling the existing grill
B) Proceed with in house manufacture since NPV is positive is closest to: (M)
C) Reject in-house manufacture since NPV is negative A) 19,500
D) Reject in-house manufacture since IRR is greater than 14% B) 30,000
Explanation: B) CF0 = -700,000 + - 40,000 = -740,000 C) 33,500
CF(1 - 9) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 = 374,500 D) 50,000
CF(10) = 500,000 units x ($2.50 - $1.80) + .35 x 700,000/10 + 40,000 = 414,500 Explanation: C) 30,000 [sale price] + .35(40,000 - 30,000) [tax write off old grill sold at loss] =
CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute NPV = 1,224,225 33,500

Use the following information to answer the question(s) below. 10) If the Krusty Krab's opportunity cost of capital is 12%, then the NPV for upgrading to the new
Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene grill is closest to: (D)
Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the A) -22,875
existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line B) -15,025
over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill C) 7,130
will produce EBITDA of $50,000 per year for the next eight years while the existing grill produces D) 10,630
EBITDA of only $35,000 per year. The current grill is being depreciated straight line over its useful Explanation: D) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] =
life of 10 years after which it will have no salvage value. All other operating expenses are identical -46,500
for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Incremental EBITDA = 50,000 - 35,000 = 15,000
Krab's tax rate is 35%. Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000
Incremental cash flow (years 1 - 8) = (15,000 - 5,000) x (1 - .35) + 5,000 = 11,500
7) The incremental cash flow that the Krusty Krab will incur today (Year 0) if they elect to upgrade CF0 = -46,500, CFj = 11,500. nj = 8, I = 12, compute NPV = 10,627.86
to the new grill is closest to: (M)
A) -80,000 11) If the Krusty Krab's opportunity cost of capital is 12%, then the IRR for upgrading to the new
B) -50,000 grill is closest to: (D)
C) -46,500 A) 3.25%
D) +30,000 B) 16.00%
Explanation: C) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] = C) 18.25%
-46,500 D) 21.00%
Explanation: C) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] =
8) The incremental cash flow that the Krusty Krab will incur in year 1 if they elect to upgrade to the -46,500
new grill is closest to: (M)
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Incremental EBITDA = 50,000 - 35,000 = 15,000 B) 27,991
Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000 C) 84,000
Incremental cash flow (years 1 - 8) = (15,000 - 5,000) x (1 - .35) + 5,000 = 11,500 D) 180,000
CF0 = -46,500, CFj = 11,500. nj = 8, compute IRR = 18.27% Explanation: B) Depreciation Tax Shield = 540,000 x .1481 x .35 = 27,991

12) If the Krusty Krab's opportunity cost of capital is 12%, what decision should the Krusty Krab
take regarding the new grill? (D)
A) Do not install the new grill since NPV is approximately = - $10,630
B) Install the new grill since NPV is approximately = + $10,630
C) Install the new grill since IRR is approximately = 15%
D) Don't install the new grill since IRR is less than 12%
Explanation: B) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] =
-46,500
Incremental EBITDA = 50,000 - 35,000 = 15,000
Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000
Incremental cash flow (years 1 - 8) = (15,000 - 5,000) x (1 - .35) + 5,000 = 11,500
CF0 = -46,500, CFj = 11,500. nj = 8, I = 12, compute NPV = 10,627.86;
compute IRR = 18.27%
7.4 Further Adjustments to Free Cash Flow
Use the following information to answer the question(s) below.
(Include the MACRS Table from the Appendix.)
Casa Grande Farms is considering purchasing multiple tractors for a total purchase price of
$540,000. These tractors are expected to generate EBITDA of $250,000 for each of the next three
years. Casa Grande Farms has a 35% tax rate and has a cost of capital of 10%.
1) Assuming that Casa Grande Farms depreciates these tractors straight line over the three year
life, then the annual depreciation tax shield in year 2 is closest to: (E)
A) 63,000
B) 80,000
C) 84,000
D) 117,000
Explanation: A) Depreciation Tax Shield = (540,000 / 3) x .35 = 63,000
2) Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation
method for three-year property starting immediately, then the annual depreciation tax shield in year
2 is closest to: (M)
A) 20,785
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3) Assuming that Casa Grande Farms depreciates these tractors straight line over the three year
life, then the NPV of buying the tractors is closest to: (M)
A) 20,785
B) 36,225
C) 81,715
D) 513,235
Explanation: A) Cash Flows (1 - 3) = (250,000 - 540,000 x 1/3) x (1 - .35) + 540,000 x 1/3 =
225,500
CF0 = - 540000, CFj = 225,500, Nj = 3, I = 10, Compute NPV = 20,785.12
4) Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation
method for three-year property starting immediately, then the NPV of buying the tractors is closest
to: (D)
A) 20,785
B) 36,225
C) 81,715
D) 513,235
E) 560,785
Explanation: B) CF0 = -540,000 + 540,000 x .3333 x .35 = -477,006.30
CF1 = (250,000 - 540,000 x .4445) x (1 - .35) + 540,000 x .4445 = 246,510.50
CF2 = (250,000 - 540,000 x .1481) x (1 - .35) + 540,000 x .1481 = 190,490.90
CF3 = (250,000 - 540,000 x .0741) x (1 - .35) + 540,000 x .0741 = 176,504.90
I = 10
Compute NPV = 36,226.30
Use the following information to answer the question(s) below.
Taggart Transcontinental is considering adding a trucking division to expand the coverage of its
existing rail lines. The trucking division will cost $1,000,000 and is expected to generate free cash
flows of $100,000 for each of the next five years. Taggart Transcontinental forecasts that future
free cash flows after year 5 will grow at 2% per year, forever. Taggart Transcontinental's cost of
capital is 10%.
5) The continuation value for the trucking division in year five is closest to: (M)
A) 1,000,000 the tax loss carry forwards in millions is 35/(1.10) 1 + 35/(1.10)2 + 35 (1.10)3 + 7/(1.10)4 = $91.82
B) 1,250,000 million
C) 1,275,000
D) 1,375,000 7.5 Analyzing the Project
Explanation: C) Continuation value (year 5) = PMT(1 + g)/(i - g) = 100,000(1.02)/(.10 - .02) = 1) Which of the following statements is false? (E)
1,275,000 A) The break-even level of an input is the level for which the investment has an IRR of zero.
B) The most difficult part of capital budgeting is deciding how to estimate the cash flows and the
6) The NPV for the trucking division is closest to: (M) cost of capital.
A) 170,750 C) When evaluating a capital budgeting project, financial managers should make the decision that
B) 200,000 maximizes NPV.
C) 212,550 D) Sensitivity analysis reveals which aspects of the project are most critical when we are actually
D) 250,000 managing the project.
E) 312,500
Explanation: A) Continuation value (year 5) = PMT(1 + g)/(i - g) = 100,000(1.02)/(.10 - .02) = 2) Which of the following statements is false? (M)
1,275,000 A) Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our NPV
PMT = 100,000, FV = 1,275,000, N = 5, I = 10, Compute PV = 1,170,753.36 - 1,000,000 = analysis for the project.
170,753.36 B) To compute the NPV for a project, you need to estimate the incremental cash flows and choose
a discount rate.
Use the following information to answer the question(s) below. C) Estimates of the cash flows and cost of capital are often subject to significant uncertainty.
Really Big Conglomerate (RBC) is considering acquiring POP, Inc. a smaller unsuccessful Internet D) When we are certain regarding the input to a capital budgeting decision, it is often useful to
firm. POP has outstanding tax loss carry forwards of $320 million from losses over the past six determine the break-even level of that input.
years. RBC has pre-tax income of $100 million per year, a cost of capital of 10%, and pays 35% in
taxes. 3) Which of the following statements is false? (M)
A) We can use scenario analysis to evaluate alternative pricing strategies for our project.
7) If RBC acquires POP, in what year will RBC be required to pay corporate taxes again: (E) B) Scenario analysis considers the effect on NPV of changing multiple project parameters.
A) 2 years C) The difference between the IRR of a project and the cost of capital tells you how much error in
B) 3 years the cost of capital it would take to change the investment decision.
C) 4 years D) Scenario analysis breaks the NPV calculation into its component assumptions and show how
D) 5 years the NPV varies as each one of the underlying assumptions change.
Explanation: C) The tax shield will last for 320/100 = 3.2 years, so in the fourth year RBC will have
(100 - 20) = 80 million in taxable income. 4) The difference between scenario analysis and sensitivity analysis is that (M)
A) scenario analysis is based upon the IRR and sensitivity analysis is based upon NPV.
8) If RBC acquires POP, then the NPV of POP tax loss carry forwards to RBC is closest to: (M) B) only sensitivity analysis allows us to change our estimated inputs of our NPV analysis.
A) $92 million C) scenario analysis considers the effect on NPV of changing multiple project parameters.
B) $236 million D) only scenario analysis breaks the NPV calculation into its component assumptions.
C) $262 million
D) $320 million 5) An exploration of the effect on NPV of changing multiple project parameters is called (E)
Explanation: A) The total of 320 in tax loss carry forwards will offset income of $100 million in A) scenario analysis.
years 1 - 3 and $20 million in year 4. The tax savings will be 35% of these amounts, so the NPV of B) IRR analysis.
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C) accounting break-even analysis. Answer:
D) sensitivity analysis. Year 0 1 2 3
Sales (Revenues) 100,000 100,000 100,000
6) An analysis that breaks the NPV calculation into its component assumptions and shows how the - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
NPV varies as one of the underlying assumptions is changed is called (E) - Depreciation 30,000 30,000 30,000
A) scenario analysis. = EBIT 20,000 20,000 20,000
B) IRR analysis. - Taxes (35%) 7000 7000 7000
C) accounting break-even analysis. = unlevered net income 13,000 13,000 13,000
D) sensitivity analysis. + Depreciation 30,000 30,000 30,000
+ changes to working capital -5,000 -5,000 10,000
7) What is sensitivity analysis? (M)
- capital expenditures -90,000
Answer: Sensitivity analysis breaks the NPV calculation into its component assumptions and
= Free Cash Flow -90,000 38,000 38,000 53,000
shows how the NPV varies as each of the underlying assumptions change. Sensitivity analysis
allows us to explore the effects of errors in your estimated inputs to our NPV calculations and
reveals which aspects of the project are most critical when we are actually managing the project. PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724
discount rate 0.12
8) How does scenario analysis differ from sensitivity analysis? (M) NPV = 11,946
Answer: Where sensitivity analysis considers the change in NPV for individual parameter changes,
scenario analysis considers the effect on NPV of change multiple project parameters 10) Epiphany would like to know how sensitive the project's NPV is to changes in the discount rate.
simultaneously. How much can the discount rate vary before the NPV reaches zero? (D)
Answer:
Use the information for the question(s) below. Year 0 1 2 3
Epiphany Industries is considering a new capital budgeting project that will last for three years. Sales (Revenues) 100,000 100,000 100,000
Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
research, it has prepared the following incremental cash flow projects: - Depreciation 30,000 30,000 30,000
= EBIT 20,000 20,000 20,000
Year 0 1 2 3 - Taxes (35%) 7000 7000 7000
Sales (Revenues) 100,000 100,000 100,000 = unlevered net income 13,000 13,000 13,000
- Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 + Depreciation 30,000 30,000 30,000
- Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000
= EBIT 20,000 20,000 20,000 - capital expenditures -90,000
- Taxes (35%) 7000 7000 7000 = Free Cash Flow -90,000 38,000 38,000 53,000
= unlevered net income 13,000 13,000 13,000
+ Depreciation 30,000 30,000 30,000 PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724
+ changes to working capital -5,000 -5,000 10,000 discount rate 0.12
- capital expenditures -90,000 NPV = 11,946
IRR = 19.14%
9) What is the NPV of the Epiphany's project? (M) So the discount rate can vary by 12% - 19.14% = 7.14%
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 NPV = 4,140
11) Epiphany is worried about the reliability of the sales forecast. How sensitive is the project's
NPV to a 10% change in sales. (D)
Answer:
Base Case
Year 0 1 2 3
Sales (Revenues) 100,000 100,000 100,000
- Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000
- Depreciation 30,000 30,000 30,000
= EBIT 20,000 20,000 20,000
- Taxes (35%) 7000 7000 7000
= unlevered net income 13,000 13,000 13,000
+ Depreciation 30,000 30,000 30,000
+ changes to working capital -5,000 -5,000 10,000
- capital expenditures -90,000
= Free Cash Flow -90,000 38,000 38,000 53,000

PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724

discount rate 0.12
NPV = 11,946
IRR = 19

10% Decrease in Sales

Year 0 1 2 3
Sales (Revenues) 90,000 90,000 90,000
- Cost of Goods Sold (50% of Sales) 45,000 45,000 45,000
- Depreciation 30,000 30,000 30,000
= EBIT 15,000 15,000 15,000
- Taxes (35%) 5250 5250 5250
= unlevered net income 9,750 9,750 9,750
+ Depreciation 30,000 30,000 30,000
+ changes to working capital -5,000 -5,000 10,000
- capital expenditures -90,000
= Free Cash Flow -90,000 34,750 34,750 49,750

PV of FCF (FCF/(1 + I)n) -90,000 31,027 27,702 35,411

discount rate 0.12

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10% Increase in Sales
Year 0 1 2 3
Sales (Revenues) 110,000 110,000 110,000
- Cost of Goods Sold (50% of Sales) 55,000 55,000 55,000
- Depreciation 30,000 30,000 30,000
= EBIT 25,000 25,000 25,000
- Taxes (35%) 8750 8750 8750
= unlevered net income 16,250 16,250 16,250
+ Depreciation 30,000 30,000 30,000
+ changes to working capital -5,000 -5,000 10,000
- capital expenditures -90,000
= Free Cash Flow -90,000 41,250 41,250 56,250

PV of FCF (FCF/(1+I)n) -90,000 36,830 32,884 40,038

discount rate 0.12
NPV = 19,752

So a + or - 10% change in sales will cause the NPV to vary between 4,140 and 19,752.

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