Test Bank for Contemporary Engineering Economics 5th Edition by Park

Test Bank for Contemporary Engineering Economics

5th Edition by Park

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Exam

Name___________________________________

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

1) A corporation is considering purchasing a machine that will save $130,000 per year before taxes. The cost of
operating the machine, including maintenance, is $20,000 per year. The machine will be needed for 4 years, after
which it will have a zero salvage value. MACRS depreciation will be used assuming a 3-year class. The allowed
depreciation amount as a percentage of the initial cost will be 33.33%, 44.45%, 14.81%, and 7.41%, respectively.
If the firm wants a 12% rate of return after taxes, how much can it afford to pay for this machine? The firm’s
income tax rate is 40%.
Answer:

The maximum amount to pay is $295,575 for this machine.

1
2) Cutter Ltd. is planning to invest $150,000 in an automated screw-cutting machine to enhance its current
operations. Due to a lack of internal funds, its management is planning to borrow 60% of the investment from a
local bank at an interest rate of 10% payable in 5 equal payments. What is the principal payment in year 2 that
should be included in the after-tax cash flow analysis?
Answer: AE(10%) = 0.6($150,000)(A/P, 10%, 5)
= $23,741.77

N Beg. Balance Interest Principal End Balance

1 $90,000 $9,000 $14,742 $74258
2 $75,258 $7,526 $16,216 $58,042

The principal payment in year 2 is $16,216.

3) Which of the following statements is most correct?

(a) Investment in working capital must be depreciated over the project life according to a straight-line method.
(b) If a project incurs an operating loss (a negative taxable income) during a typical tax year, the firm pays no
income taxes during that year.
(c) Whenever a project requires an investment in working capital, the profitability of the project will be
affected negatively.
(d) None of the above
Answer: (c)

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4) A special purpose machine tool set would cost $20,000. The entire capital expenditure ($20,000) is to be
borrowed with the stipulation that it be repaid by 2 equal end-of-year payments at 10%, compounded annually
( or $11,524 per year). The tool is expected to provide annual savings (material) of $35,000 for 2 years and is to
be depreciated by the MACRS 3-year recovery period. And this special machine tool will require annual O&M
costs in the amount of $5,000. The salvage value at the end of 2 years is expected to be $6,000. The project
requires an investment in working capital in the amount of $3,000, but the entire amount will be recovered at
the end of project life. Assuming a marginal tax rate of 40% and MARR of 15%, what is the net present worth of
this project?
Answer:

3
5) You are considering purchasing industrial equipment to expand one of your production lines. The equipment
costs $100,000 and has an estimated service life of 6 years. Assuming that the equipment will be financed
entirely from your business-retained earnings (equity funds), a fellow engineer has calculated the expected
after tax cash flows, including the salvage value, at the end of its project life are as follows:

End of Year Net Cash Flow

0 -$100,000
1-5 500,000
6 600,000

Now you are pondering the possibility of financing the entire amount by borrowing from a local bank at 12%
interest. You can make an arrangement to pay only the interest each year over the project period by deferring
the principal payment until the end of 6 years. Your firm’s interest rate is also 12%. The expected marginal
income tax rate over the project period is known to be 40%. What is the amount of economic gain (or loss) in
present worth by using debt financing over equity financing?
Answer: Note that the borrowing rate is the same as the MARR. Since there will be tax savings from equity
financing (retained earnings), the economic gains ($29,519) from using debt financing represents entirely
savings from interest deduction.

6) Oxford Manufacturing Company needs an air compressor and has narrowed the choice to two alternatives, A
and B. The following financial data have been collected:

Model A Model B
First cost $25,000 $35,000
Annual O&M cost 5,600 3,500
Salvage value 0 4,000
Service life 10 years 10 years
Depreciation 5-year MACRS 5-year MACRS

The marginal tax rate is 40%. Which of the following statements is incorrect? Assume the MARR = 20%.

(a) Select Model A because you can save $440 annually.

(b) Select Model A because its incremental rate of return (Model A — Model B) exceeds 20%.
(c) Select Model A because you can save $1,845 in present worth.
(d) Select Model A because its incremental rate of return (Model B — Model A) is 14.12%, which is less than
20%.

4
Answer: (b)

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7) You are planning to lease an automobile for 36 months from a local dealer. The negotiated price is $20,000. The
required security deposit is $500 at the time of the lease and will be refunded in full at the end of the lease. The
monthly lease payable at the end of each month is calculated to be $300. The dealer will depreciate the asset
over five years with a salvage value of 10% of the original purchase price. What kind of residual value (salvage
value) was assumed by the dealer in calculating the monthly lease? The dealer’s after-tax interest rate is known
to be 9%, compounded monthly. Assume that the dealer’s tax rate is 35%.
Answer: • Investment = $20,000
• Security deposit at n = 0: $500
• Monthly after-tax cash flows:
o Lease payment: $300(1 — 0.35) = $195
o Monthly Depreciation: ($20,000 - $2,000)/60 = $300
o Depreciation credit = $300 (0.35) = $105
o Monthly after-tax cash flow: $195 + $105 = $300

• Assumed the salvage value at n = 3 years: S

• Refund of security deposit n = 3 years = $500
• Monthly interest rate:
0.09 1
i= 1+ - 1 = 0.0075
12
• Cash inflow:
$500 + $300(P/A, 0.75%, 36) + [S - 0.35(S - $9,200)](P/F, 0.75%, 36)
= $500 + $9,434.04 + 0.7642S - 0.35(0.7642S) + $7,030.17)
= $16,964.21 + 0.49673S

• Cash outflow:
$20,000 + $500(P/F, 0.75%, 36) = $20,382.07

• Breakeven salvage value:

$16,964.21 + 0.49673S = $20,382.07
S = $6,880.72

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8) Consider the following financial data for an investment project:
• Required capital investment at n = 0: $250,000
• Project service life: 5 years
• Salvage value at the end of 5 years: $65,000
• Depreciation method for tax purposes: 5-year MACRS
• Annual revenue: $350,000
• Annual O&M expenses (not including depreciation and interest): $210,000
• Required investment in working capital at n = 0 (which will be recovered in full at the end of project year):
$50,000
• The income tax rate to use: 40%
Determine the project cash flow at the end of year 5.
Answer:

9) Lane Construction Ltd. is considering the acquisition of a new eighteen-wheeler.

• The truck’s base price is $80,000, and it will cost another $20,000 to modify it for special use by the
company.
• This truck falls into the MACRS five-year class. It will be sold after three years for $30,000.
• The truck purchase will have no effect on revenues, but it is expected to save the firm $45,000 per year in
before-tax operating costs, mainly in leasing expenses.
• The firm’s marginal tax rate (federal plus state) is 40%, and its MARR is 15%.

(a) Is this project acceptable, based on the most likely estimates given in the problem?
(b) If the firm’s MARR is increased to 25%, what would be the required savings in leasing so that the project
would remain profitable?

7
Answer: (a)

This project is acceptable.

(b)

The project would remain profitable with the minimum required savings of $56,661.

8
10) A corporation is considering purchasing a machine that will save $200,000 per year before taxes. The cost of
operating the machine, including maintenance, is $80,000 per year. The machine costing $150,000 will be
needed for 5 years, after which it will have a salvage value of $25,000. A straight-line depreciation with no
half-year convention applies (i.e., 20% each year). If the firm wants 15% rate of return after taxes, what is the net
present value of the cash flows generated from this machine? The firm’s income tax rate is 40%.
Answer:

9
Answer Key
Testname: C10

1)

The maximum amount to pay is $295,575 for this machine.

2) AE(10%) = 0.6($150,000)(A/P, 10%, 5)

= $23,741.77

N Beg. Balance Interest Principal End Balance

1 $90,000 $9,000 $14,742 $74258
2 $75,258 $7,526 $16,216 $58,042

The principal payment in year 2 is $16,216.

3) (c)

10
Answer Key
Testname: C10

4)

5) Note that the borrowing rate is the same as the MARR. Since there will be tax savings from equity financing (retained
earnings), the economic gains ($29,519) from using debt financing represents entirely savings from interest deduction.

11
Answer Key
Testname: C10

6) (b)

12
Answer Key
Testname: C10

7) • Investment = $20,000
• Security deposit at n = 0: $500
• Monthly after-tax cash flows:
o Lease payment: $300(1 — 0.35) = $195
o Monthly Depreciation: ($20,000 - $2,000)/60 = $300
o Depreciation credit = $300 (0.35) = $105
o Monthly after-tax cash flow: $195 + $105 = $300

• Assumed the salvage value at n = 3 years: S

• Refund of security deposit n = 3 years = $500
• Monthly interest rate:
0.09 1
i= 1+ - 1 = 0.0075
12
• Cash inflow:
$500 + $300(P/A, 0.75%, 36) + [S - 0.35(S - $9,200)](P/F, 0.75%, 36)
= $500 + $9,434.04 + 0.7642S - 0.35(0.7642S) + $7,030.17)
= $16,964.21 + 0.49673S

• Cash outflow:
$20,000 + $500(P/F, 0.75%, 36) = $20,382.07

• Breakeven salvage value:

$16,964.21 + 0.49673S = $20,382.07
S = $6,880.72

13
Answer Key
Testname: C10

8)

9) (a)

This project is acceptable.

(b)
14
Answer Key
Testname: C10

The project would remain profitable with the minimum required savings of $56,661.

15
Test Bank for Contemporary Engineering Economics 5th Edition by Park

Answer Key
Testname: C10

10)

16

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