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Chapter 9 Study Notes

Chapter 9 [Old exam conceptual questions]


1- A company owns a building that is totally paid for. This building has been sitting idle for the
past three years. Now the company is trying to analyze a project that would include the
use of this building. Which of the following costs should not be included in that analysis?
I. The property taxes paid on the building over the past three years
II. The insurance paid on the building over the past three years
III. The current market value of the building
IV. The cost to survey the lot to construct a drainage pond required for the project
A) I and II only
B) III and IV only
C) I, II, and III only
D) I, II, and IV only
E) I, II, III, and IV

2- Which of the following would likely cause erosion?


I. A gas station owner expands floor space to make room for a convenience store.
II. You begin selling coffee in new, small-sized pouches alongside your regular-sized
coffee cans.
III. You open a Harvey’s just down the street from your McDonalds franchise.
A) I only
B) I and II only
C) III only
D) I and III only
E) II and III only

3- ABC Co. purchased a tract of land last year for $1.2 million. At that time, the company spent
$50,000 in legal fees to have the land rezoned for commercial use and another $175,000
to have the land graded so that it is usable. The company is now trying to decide if they
want to build one large retail store on the property or a strip mall consisting of smaller
stores. Which of the costs identified above should be included in the project analysis to
determine the best use of the property?
A) None of the identified costs
B) Only the cost of the land and the grading
C) Only the legal fees and the grading costs
D) Only the cost of the grading
E) All of the identified costs
4- Erosion, in a financial sense, is defined as:
A) The expense created on an annual basis from reducing the book value of fixed
assets.
B) The deterioration of the book value of new assets obtained when a new project is
implemented.
C) The diminishing cash flows created by a new project over time.
D) The negative impact on the current cash flows from an existing product when a new
product is introduced.
E) The effect of taxation on the additional cash flows created when a new project or
activity is implemented.

5- A taxable gain occurs when an asset is sold for more than its book value. For capital
budgeting purposes, the taxes on the sale ____________________________.
A) are treated as a reduction in cash and added to operating cash flow
B) are treated as a noncash event similar to depreciation
C) are treated as a reduction in cash and deducted from the book value of the asset
D) are treated as a reduction in cash and deducted from the taxable gain
E) are treated as a reduction in cash and are deducted from the sale price

6- Nicole sent a letter inquiring about the cost of a piece of equipment for a project she is
considering. The cost of the stamp to mail this letter is an example of a(n) _____ cost.
A) Opportunity
B) Relevant
C) Erosion
D) Sunk
E) Incremental

7- Which of the following are considered cash flows of a project?


I. Taxes
II. Financing costs
III. Sunk costs
IV. Opportunity costs
A) I and II only
B) I and IV only
C) III and IV only
D) II and IV only
E) I, II, and IV only
8- A company is evaluating the replacement of the office copier. Which of the following should
be considered in that evaluation?
I. The balance due on the current lease, which will be payable even if the copier is
returned.
II. The cost of the maintenance contract on the new copier.
III. The costs of repairs made today on the existing copier.
IV. The selling price of the existing copier.
A) I and II only
B) II and III only
C) II and IV only
D) I, II, and IV only
E) II, III, and IV only

9- Project cash flows will increase when:


A) Capital spending for the project increases.
B) The inventory requirements for a project increase.
C) The depreciation associated with a project decreases.
D) The projected sales resulting from the project increase.
E) The incremental change in accounts payable decreases.

10- There may be a bias against accepting capital budgeting projects if


A) Cash outflows are underestimated.
B) The discount rate is underestimated.
C) Opportunity costs are not accounted for.
D) Inflation in cash inflow estimation is ignored.
E) Sunk costs are excluded.

11- If a company making only cash sales is considering allowing customer credit, then
__________.
A) sales will likely decrease
B) the change will result in a source of funds
C) receivables will likely increase
D) all of the above
E) none of the above

12- Which of the following is not considered a relevant, incremental cash flow in capital
budgeting analysis?
A) Opportunity costs
B) Erosion costs
C) Additions to net working capital
D) Sunk costs
E) Fixed asset salvage values
13- When we employ ________________ when we are evaluating a project on the basis of its
incremental cash flows, thereby ignoring the other cash flows of the firm.
A) the stand-alone principle
B) the equivalence theorem
C) the equivalent annual cost procedure
D) all of the above
E) none of the above

14- Operating cash flow is defined as:


A) Earnings before interest and taxes (EBIT) minus depreciation plus taxes.
B) The change in net working capital plus depreciation minus taxes.
C) Earnings before interest and taxes (EBIT) minus taxes plus depreciation.
D) Sales minus costs minus depreciation plus taxes.
E) Sales minus variable costs minus fixed costs minus depreciation minus taxes.

Chapter 9 [Old exam Problems]


1- A company is considering the acquisition of production equipment which will reduce
material costs. The company pays a consulting firm $52,000 to conduct an analysis in
order to determine whether the acquisition of the equipment will be a positive NPV
project. The cost of the equipment is $178,000 and it will be depreciated using the 3-year
MACRS method. However, the useful life of the equipment is five years, and it will be
sold for $28,000 at the end of five years. Operating costs will be reduced by $30,000 in
the first year and the savings will increase by $5,000 per year for years 2, 3, and 4. Due to
increase maintenance costs, savings in year 5 will be $10,000 less than year 4 savings.
The interest expense is $5,000 in the first year and it increases by $500 per year for years
2, 3, 4, and 5. The equipment will also reduce inventory by $10,000, increase accounts
receivable by $4,500 and reduce accounts payable by $6,000. The inventory, accounts
receivable, and accounts payable will revert back to normal at the end of the project. The
firm’s tax rate is 35% and the firm requires a 13.5% return. Calculate the project’s NPV
and IRR. Based on the NPV decision rule should the company accept the project? Based
on the IRR decision rule should the company accept the project? (Carry one decimal
point when necessary)

Solution:
3 year MACRS
Year % Depreciation $ Depreciation
1 33.33 59,327.4
2 44.44 79,103.2
3 14.82 26,379.6
4 7.41 13,189.8

MV at the end of year 5 = $28,000; BV at the end of year 5 = $0

Cash Flow at year 0

FA -178,000
↓Inv. 10,000
↑AR -4,500
↓AP -6,000
CF0 -$178,500

Annual Cash Flows

Year1 Year 2 Year 3 Year 4 Year 5

Sales 0 0 0 0 0

Costs -(30,000) -(35,000) -(40,000) -(45,000) -(35,000)

Dep. -59,327.4 -79,103.2 -26,379.6 -13,189.8 0

EBIT -29,327.4 -44,103.2 13,620.4 31,810.2 35,000

T (35%) -(10,264.6) -(15,436.1) -4,767.1 -11,133.6 -12,250

EAT -19,062.8 -28,667.1 8,853.3 20,676.6 22,750

Dep. 59,327.4 79,103.2 26,379.6 13,189.8 0

ACF $40,264.6 $50,436.1 $35,232.9 $33,866.4 $22,750

CF1 CF2 CF3 CF4 ACF5

Terminal Cash Flow

Sell FA 28,000
Taxes -9,800 (MV – BV) T → (28,000 – 0) (0.35)
↑Inv. -10,000
↓AR 4,500
↑AP 6,000
TCF $18,700

Total CF5 = Annual CF5 + Terminal CF5 = $22,750 + $18,700= $41,450

CF0 -$178,500
CF1 $40,264.6
CF2 $50,436.1
CF3 $35,232.9
CF4 $33,866.4
CF5 $41,450
I/YR 13.5

NPV = -$37,362.57

The firm should reject the project since NPV is -ve

IRR = 4.24%
The firm should reject the project since the IRR is less than the required rate of return

2- A company is considering the acquisition of production equipment which will reduce


both labor and material costs. The cost of the equipment is $160,000 and it will be
depreciated on a straight-line basis to zero over a four-year period. However, the useful
life of the equipment is five years, and it will be sold for $45,000 at the end of the five
years. Operating costs will be reduced by $34,000 in the first year and the savings will
increase by $6,000 per year for years 2, 3, and 4. Due to increased maintenance costs,
savings in year 5 will be $10,000 less than the savings in year 4. The interest expense is
$3,125 in the first year and it increases by $400 per year for years 2, 3, 4, and 5. The
equipment will reduce inventory by $10,000 at the beginning of the project. The
inventory will revert back to normal at the end of the project. The firm’s tax rate is 40%
and the firm requires a 16% return. Calculate the initial investment, the annual cash
flows, and the NPV for the project. Based on the NPV decision rule, should the company
accept or reject this project? Based on the IRR, should the company accept the project?

Solution:
Depreciation = (160,000) / 4 = $40,000 per year
MV at the end of year 5 = $45,000; BV at the end of year 5 = $0

Cash Flow at year 0


FA -160,000
↓ Inv. 10,000
CF0 -$150,000

Annual Cash Flows

Year1 Year 2 Year 3 Year 4 Year 5

Sales 0 0 0 0 0

Costs -(34,000) -(40,000) -(46,000) -(52,000) -(42,000)

Dep. -40,000 -40,000 -40,000 -40,000 0

EBT -6,000 0 6,000 12,000 42,000

T (40%) -(2,400) -0 -2,400 -4,800 -16,800

EAT -3,600 0 3,600 7,200 25,200

Dep. 40,000 40,000 40,000 40,000 0

ACF $36,400 $40,000 $43,600 $47,200 $25,200

CF1 CF2 CF3 CF4 ACF5

Terminal Cash Flow

Sell FA 45,000
Taxes -18,000 (MV – BV) T → (45,000 – 0) (0.4)
↑Inv. -10,000
TCF5 $17,000

Total CF5 = Annual CF5 + Terminal CF5 = 25,200+ 17,000 = $42,200

CF0 -150,000
CF1 36,400
CF2 40,000
CF3 43,600
CF4 47,200
CF5 42,200
I/YR 16

NPV -$14,801.39
The firm should reject the project since NPV is -ve

IRR = 11.83%
The firm should reject the project because the IRR is less than the required rate of return.

Use the following to answer questions 3-7:

The managers of ABC Inc. plan to manufacture engine blocks for classic cars from the 1960s
era. They expect to sell 250 blocks annually for the next five years. The necessary foundry and
machining equipment will cost a total of $800,000 and will be depreciated using the MACRS
three-year class. The firm expects to be able to sell the manufacturing equipment for $150,000 at
the end of the project. Labour and materials costs total $500 per engine block, fixed costs are
$125,000 per year and auto restorers will pay $3,000 retail per engine block. Assume a 35% tax
rate and a 12% discount rate. [use one decimal in your calculations]

3- What is the cash flow for the project in year 1?


A) $97,500
B) $449,432
C) $418,324
D) $325,000
E) $203,996

4- What is the cash flow for the project in year 3?


A) $97,500
B) $449,432
C) $418,324
D) $325,000
E) $366,496

5- What is the terminal cash flow for the project?


A) $97,500
B) $449,432
C) $418,324
D) $325,000
E) $203,996
6- What is the NPV of this project?
A) $260,769
B) $401,187
C) $536,455
D) $624,674
E) $652,120

7- What is the IRR of the project?


A) 27%
B) 42%
C) 34%
D) 32%
E) 45%

Solution:

I- Initial Investment:
Cash Flow at year 0
Initial Investment -800,000
CF0 -$800,000

3 year MACRS
Year % Depreciation $ Depreciation
1 33.33 $266,640
2 44.44 $355,520
3 14.82 $118,560
4 7.41 $59,280

MV at the end of year 5 = $150,000; BV at the end of year 5 = $0

II- Annual Cash Flows


Year1 Year 2 Year 3 Year 4 Year 5

Sales 750,000 750,000 750,000 750,000 750,000

Variable Costs -125,000 -125,000 -125,000 -125,000 -125,000

Fixed Costs -125,000 -125,000 -125,000 -125,000 -125,000

Dep. -266,640 -355,520 -118,560 -59,280 -0

EBT 233,360 144,480 381,440 440,720 500,000

T (35%) -81,676 -50,568 -133,504 -154,252 -175,000


EAT 151,684 93,912 247,936 286,468 325,000

Dep. +266,640 +355,520 +118,560 +59,280 +0

ACF 418,324 449,432 366,496 345,748 325,000

CF1 CF2 CF3 CF4 ACF5

III- Terminal Cash Flow

Sell FA $150,000
T (35%) -52,500 (MV – BV) T → (150,000 – 0) (0.35)
TCF $97,500

Total CF5 = Annual CF5 + Terminal CF = $325,000+ $97,500 = $422,500

NPV = $652,119.575
IRR = 42.287931%

Use the following to answer questions 8-10:

The managers of ABC Inc. plan to manufacture engine blocks for classic cars from the 1960s
era. They expect to sell 250 blocks annually for the next five years. The necessary foundry and
machining equipment will cost a total of $800,000 and will be depreciated using the MACRS
three-year class. The firm expects to be able to sell the manufacturing equipment for $150,000 at
the end of the project. Labour and materials costs total $500 per engine block, fixed costs are
$125,000 per year and auto restorers will pay $3,000 retail per engine block. Assume a 35% tax
rate and a 12% discount rate.

8- What is the cash flow for the project in year 1?


A) $97,500
B) $449,432
C) $418,324
D) $325,000
E) $203,996
9- What is the cash flow for the project in year 5?
A) $97,500
B) $422,500
C) $418,324
D) $325,000
E) $203,996

10- What is the NPV of this project?


A) $260,769
B) $401,187
C) $536,455
D) $624,674
E) $652,120

Solution:

I- Initial Investment:
Cash Flow at year 0
Initial Investment -800,000
CF0 -$800,000

3 year MACRS
Year % Depreciation $ Depreciation
1 33.33 $266,640
2 44.44 $355,520
3 14.82 $118,560
4 7.41 $59,280

MV at the end of year 5 = $150,000; BV at the end of year 5 = $0

II- Annual Cash Flows


Year1 Year 2 Year 3 Year 4 Year 5

Sales 750,000 750,000 750,000 750,000 750,000

Variable Costs -125,000 -125,000 -125,000 -125,000 -125,000

Fixed Costs -125,000 -125,000 -125,000 -125,000 -125,000

Dep. -266,640 -355,520 -118,560 -59,280 -0

EBT 233,360 144,480 381,440 440,720 500,000


T (35%) -81,676 -50,568 -133,504 -154,252 -175,000

EAT 151,684 93,912 247,936 286,468 325,000

Dep. +266,640 +355,520 +118,560 +59,280 +0

ACF 418,324 449,432 366,496 345,748 325,000

CF1 CF2 CF3 CF4 ACF5

III- Terminal Cash Flow

Sell FA $150,000
T (35%) -52,500 (MV – BV) T → (150,000 – 0) (0.35)
TCF $97,500

Total CF5 = Annual CF5 + Terminal CF = $325,000+ $97,500 = $422,500


NPV = $652,119.575

Use the following to answer questions 11-15:

A company is considering a new project. This project will require the purchase of $321,000 of
equipment, the purchase of $45,000 in inventory and will increase accounts payable by
$73,000. Expected sales are $625,000 with costs of $480,000. The project will last for
five years, be taxed at 35% and have a required rate of return of 14%. The equipment
will have no salvage value at the end of the project and will be depreciated using the
MACRS three-year class. The increase in inventory and accounts payable will revert
back to normal at the ends of the project’s life. [When necessary, please carry one
decimal in your calculations]

11- What is the annual cash flow for year 1 of the project?
A) $66,250
B) $88,720
C) $110,900
D) $116,720
E) $131,696
12- What is the annual cash flow for year 3 of the project?
A) $66,250
B) $88,720
C) $110,900
D) $116,720
E) $131,696

13- What is the total cash flow for year 5 of the project?
A) $66,250
B) $88,720
C) $110,900
D) $116,720
E) $131,696

14- What is the net present value (NPV) of this project?


A) $93,167
B) $103,459
C) $144,178
D) $78,056
E) $107,709

15- What is the internal rate of return (IRR) of this project?


A) 22%
B) 25%
C) 30%
D) 33%
E) 27%

Solution:

Initial Investment:
Cash Flow at year 0
Initial Investment -321,000
↑Inv. -45,000
↑AP 73,000
CF0 -$293,000
3 year MACRS
Year % Depreciation $ Depreciation
1 33.33 $106,989.3 →[0.3333 * $321,000]
2 44.44 $142,652.4 →[0.4444 * $321,000]
3 14.82 $47,572.2 →[0.1482 * $321,000]
4 7.41 $23,786.1 →[0.0741 * $321,000]

MV at end of year 5 = $0 and BV at end of year 5 = $0

II- Annual Cash Flows


Year1 Year 2 Year 3 Year 4 Year 5

Sales 625,000 625,000 625,000 625,000 625,000

Costs -480,000 -480,000 -480,000 -480,000 -480,000

Dep. -106,989.3 -142,652.4 -47,572.2 -23,786.1 -0

EBT 38,010.7 2,347.6 97,427.8 121,213.9 145,000

T (35%) -13,303.7 -821.7 -34,099.7 -42,424.9 -50,750

EAT 24,707 1,525.9 63,328.1 78,789.1 94,250

Dep. +106,989.3 +142,652.4 +47,572.2 +23,786.1 +0

ACF $131,696.3 $144,178.3 $110,900.3 $102,575.2 $94,250

CF1 CF2 CF3 CF4 ACF5

III- Terminal Cash Flow

Sell FA $0
T (35%) -$0 (MV – BV) T → ($0 – $0) (0.35)
↓Inv. $45,000
↓AP -$73,000
TCF -$28,000

Total CF6 = Annual CF6 + Terminal CF = $94,250 - $28,000= $66,250

NPV = $103,459.1
IRR = 29.6%

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