Chap 006

Chapter 06 - Making Investment Decisions with the Net Present Value Rule
Chapter 06
Making Investment Decisions with the Net Present Value Rule
Multiple Choice Questions
1. Important points to remember while estimating cash flows of projects are:

I) only cash flow is relevant
II) always estimate cash flows on an incremental basis
III) be consistent in the treatment of inflation
A. I only
B. I and II only
C. II, and III only
D. I,II, and III
2. Preferably, cash flows for a project are estimated as:

A. Cash flows before taxes
B. Cash flows after taxes
C. Accounting profits before taxes
D. Accounting profits after taxes
3. When a firm has the opportunity to add a project that will utilize excess factory capacity
(that is currently not being used), which costs should be used to determine if the added project
should be undertaken?
A. Opportunity cost
B. Sunk cost
C. Incremental costs
D. None of the above
4. A reduction in the sales of existing products caused by the introduction of a new product is
an example of:
A. incidental effects
B. opportunity cost
C. sunk cost
D. none of the above
6-1
5. For example, when Honda develops a new engine, the incidental effects might include the
following:
I) demand for replacement parts
II) profitable service facilities
III) offer modified or improved versions of the engine for other uses
A. I only
B. I and II only
C. I,II, and III
D. None of the given ones
6. The cost of a resource that may be relevant to an investment decision even when no cash
changes hand is called a (an):
A. Sunk cost
B. Opportunity cost
C. Working capital
7. Net Working Capital is the:

I) short-term assets
II) short term liabilities
III) long-term assets
IV) long term liabilities
A. I only
B. (I - II)
C. (III - I)
D. (III - IV)
8. Investment in net working capital is not depreciated because:

A. It is not a cash flow
B. It is recovered during or at the end of the project and is not a depreciating asset
C. It is a sunk cost
D. All of the above
6-2
9. Net Working Capital should be considered in project cash flows because:

A. Firms must invest cash in short-term assets to produce finished goods
B. They are sunk costs
C. Firms need positive NPV projects for investment
10. Investment in inventories includes investment in:

I) Raw material
II) Work-in-progress
III) Finished goods
A. I only
B. I and II only
C. I, II, and III
D. III only
11. For example, in case of an electric car project, the following cash flows should be treated
as incremental flows when deciding whether to go ahead with the project except:
A. The consequent reduction in sales of the company's existing gasoline models (i.e.:
incidental effects)
B. Interest payment on debt
C. The value of tools that can be transferred from the company's existing plants
D. The expenditure on new plants and equipment
12. The principal short-term assets are:

I) Cash, II) Accounts receivable, III) Inventories, and IV) Accounts Payable
A. I only
B. I and IV only
C. I, II, and III
D. IV only
6-3
13. The value of a previously purchased machine to be used by a proposed project is an

example of:
A. Sunk cost
B. Opportunity cost
C. Fixed cost
14. Money that a firm has already spent or committed to spend regardless of whether a project
is taken is called:
A. Fixed cost
B. Opportunity cost
C. Sunk cost
15. The cost that is incurred as a result of past, irrevocable decisions and is irrelevant to future
decisions is called:
A. Opportunity cost
B. Sunk cost
C. Incremental cost
16. For example, in the case of an electric car project, which of the following cash flows
should be treated as incremental flows when deciding whether to go ahead with the project?
A. The cost of research and development undertaken for developing the electric car in the past
three years
B. The annual depreciation charge
C. Tax savings resulting from the depreciation charges
D. Dividend payments
17. In the case of freely traded resources, opportunity cost is the:

A. book value
B. market value
C. historical value
6-4
18. If the discount rate is stated in nominal terms, then in order to calculate the NPV in a
consistent manner requires that project:
I) cash flows be estimated in nominal terms
II) cash flows be estimated in real terms
III) accounting income be used
A. I only
B. II only
C. III only
19. If the discount rate is stated in real terms, then in order to calculate the NPV in a
A. I only
B. II only
C. III only
20. A firm owns a building with a book value of $150,000 and a market value of $250,000. If
the building is utilized for a project, then the opportunity cost ignoring taxes is:
A. $100,000
B. $150,000
C. $250,000
21. The real interest rate is 3% and the inflation rate is 5%. What is the nominal interest rate?
A. 3%
B. 5%
C. 8.15%
D. 2%
6-5
22. If the nominal interest rate is 7. 5% and the inflation rate is 4%, what is the real interest
rate?
A. 4%
B. 9.5%
C. 3.4%
23. A cash flow received in two years is expected to be $10,816 in nominal terms. If the real
rate of interest is 2% and the inflation rate is 4%, what is the real cash flow for year-2?
A. $11,236
B. $10,816
C. $10,000
D. $9,246
24. Given the following data for Project M:
A. $51.70
B. $35.54
C. $45.21
A. $25.85
B. $17.77
C. $22.65
6-6
26. The real rate of interest is 3% and the inflation is 4%. What is the nominal rate of
interest?
A. 3%
B. 4%
C. 7.12%
D. 1%
27. The NPV value obtained by discounting nominal cash flows using the nominal discount
rate is the:
I) same as the NPV value obtained by discounting real cash flows using the real discount rate
II) same as the NPV value obtained by discounting real cash flows using the nominal discount
rate
III) same as the NPV value obtained by discounting nominal cash flows using the real
discount rate
A. I only
B. II only
C. III only
D. II and III only
28. Real cash flow occurring in year-2 is $60,000. If the inflation rate is 5% per year, the real
rate of interest is 2%, calculate the cash flow for the year-2.
A. $60,000
B. $55,422
C. $66,150
29. Proper treatment of inflation in the NPV calculation involves:

I) Discounting nominal cash flows using the nominal discount rate
II) Discounting real cash flows using the real discount rate
III) Discounting nominal cash flows using the real discount rates
A. I only
B. II only
C. III only
D. I and II only
6-7
30. A firm has a general-purpose machine, which has a book value of $300,000 and is sold for
$500,000 in the market. If the tax rate is 35%, what is the opportunity cost of using the
machine in a project?
A. $500,000
B. $430,000
C. $300,000
31. Capital equipment costing $250,000 today has 50,000 salvage value at the end of 5 years.
If the straight line depreciation method is used, what is the book value of the equipment at the
end of two years?
A. $200,000
B. $170,000
C. $140,000
D. $50,000
32. A capital equipment costing $400,000 today has no (zero) salvage value at the end of 5
years. If straight-line depreciation is used, what is the book value of the equipment at the end
of three years?
A. $120,000
B. $80,000
C. $160,000
D. $240,000
33. For project Z, year-5 inventories increase by $6,000, accounts receivables by $4,000 and
accounts payables by $3,000. Calculate the increase or decrease in working capital for year-5.
A. Increases by $6,000
B. Decreases by $4,000
C. Increases by $7,000
D. Decreases by $7,000
6-8
34. For project A in year-2, inventories increase by $12,000 and accounts payable by $2,000.
Calculate the increase or decrease in net working capital for year-2.
A. Decreases by $14,000
B. Increases by $14,000
C. Decreases by $10,000
D. Increases by $10,000
35. Working capital is one of the most common causes of misunderstanding in estimating
project cash flows. The following are the most common errors:
I) forgetting about working capital entirely
II) forgetting that working capital may change during the life of the project
III) forgetting that working capital is recovered at the end of the project
IV) forgetting to depreciate the working capital
A. I and II only
B. I, II, and III only
C. II,III and IV only
D. I,II and IV only
36. If the depreciation amount is 600,000 and the marginal tax rate is 35%, then the tax shield
due to depreciation is:
A. $210,000
B. $600,000
C. $390,000
37. If the depreciation amount is $100,000 and the marginal tax rate is 35%, then the tax
shield due to depreciation is:
A. $35,000
B. $100,000
C. $65,000
6-9
38. If the depreciable investment is $600,000 and the MACRS 5-Year class schedule is:
Year-1: 20%; Year-2: 32%; Year-3: 19.2%; Year-4: 11.5%; Year-5: 11.5% and Year-6: 5.8%
Calculate the depreciation for Year-2.
A. $120,000
B. $192,000
C. $96,000
D. $115,200
39. If the depreciable investment is $1,000,000 and the MACRS 5-Year class schedule is:
Calculate the depreciation tax shield for Year-2 using a tax rate of 30%:
A. $224,000
B. $60,000
C. $96,000
D. $300,000
40. A project requires an initial investment of $200,000 and is expected to produce a cash
flow before taxes of 120,000 per year for two years. [i.e. cash flows will occur at t = 1 and t =
2]. The corporate tax rate is 30%. The assets will be depreciated using MACRS - 3 year
schedule: (t=1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is
such that it can make use of all applicable tax shields. The opportunity cost of capital is 12%.
Assume that the asset can be sold for book value. Calculate the NPV of the project:
(Approximately)
A. $22,463
B. $19,315
C. $16,244
6-10
Assume that the asset can be sold for book value. Calculate the IRR for the project:
(approximately)
A. 12.00%
B. 11.00%
C. 17.73%
42. You have been asked to evaluate a project with infinite life. Sales and costs are projected
to be $1000 and $500 respectively. There is no depreciation and the tax rate is 30%. The real
required rate of return is 10%. The inflation rate is 4% and is expected to be 4% forever. Sales
and costs will increase at the rate of inflation. If the project costs $3000, what is the NPV?
A. $500.00
B. $1629.62
C. $365.38
43. A project requires an investment of $900 today. It has sales of $1,100 per year forever.
Costs will be $600 the first year and increase by 20% per year. Ignoring taxes calculate the
NPV of the project at 12% discount rate.
A. $65.00
B. $57.51
C. $100.00
D. Cannot be calculated as g > r
44. Which of the following countries allow firms to keep two separate sets of books, one for
the stockholders and one for the tax authorities like the Internal Revenue Service?
I) U.S.A., II) Japan, and III) France
A. I only
B. I and II only
C. I, II, and III only
6-11
45. Germany allows firms to choose the following depreciation methods:

I) Straight-line method, and II) Declining-balance method
A. I only
B. II only
C. I and II only
D. Germany allows a totally different system
46. Two machines, A and B, which perform the same functions, have the following costs and
lives.
Which machine would you choose? The two machines are mutually exclusive and the cost of
capital is 15%.
A. Machine A as the EAC is $1789.89
B. Machine B as the EAC is $1922.88
C. Don't buy either machine
D. Accept both A and B
47. Two mutually exclusive projects have the following NPVs and project lives.
If the cost of capital is 15%, which project would you accept?

A. A
B. B
C. Both A and B
D. Reject both A and B
6-12
48. OM Construction Company must choose between two types of cranes. Crane A costs
$600,000, will last for 5 years, and will require $60,000 in maintenance each year. Crane B
costs $750,000 and will last for seven years and will require $30,000 in maintenance each
year. Maintenance costs for cranes A and B are incurred at the end of each year. The
appropriate discount rate is 12% per year. Which machine should OM Construction
purchase?
A. Crane A as EAC is $226,444
B. Crane B as EAC is $194,336
C. Crane A as the PV is $816,286
D. Cannot be calculated as the revenues for the project are not given
49. You are considering the purchase of one of two machines required in your production
process. Machine A has a life of two years. Machine A costs $50 initially and then $70 per
year in maintenance. Machine B has an initial cost of $90. It requires $40 in maintenance for
each year of its 3 year life. Either machine must be replaced at the end of its life. Which is the
better machine for the firm? The discount rate is 15% and the tax rate is zero.
A. Machine A as EAC for Machine A is $100.76
B. Machine B as EAC for Machine B is $79.42
C. Machine A as PV of costs for Machine A is $163.80
D. Machine B as PV of costs for Machine B is $181.33
50. RainMan Inc. is in the business of producing rain upon request. They must decide
between two investment projects; a new airplane for seeding rain clouds or a new weather
control machine built by Dr. Nutzbaum. The discount rate for the new airplane is 9%, while
the discount rate for the weather machine is 39% (it happens to be higher risk). Which
investment should the company select and why?
A. Airplane because is has a higher NPV

B. Weather machine because is has a higher NPV
C. Airplane because is has a higher annuity
D. Weather machine because is has a higher annuity
6-13
51. Using the technique of equivalent annual cash flows and a discount rate of 7%, what is the
value of the following project?
A. 3.06
B. 3.61
C. 10.25
D. 12.23
True / False Questions
52. When calculating cash flows, it is important to consider them on an incremental basis.
True False
53. When calculating cash flows, it is important to consider all incidental effects.
True False
54. Opportunity costs should not be included as they are missed opportunities.
True False
55. Working capital is needed additional investment in the project and should considered for
cash flow estimation.
True False
56. Sunk costs are bygones, they are unaffected by the decision to accept or reject and should
be ignored.
True False
6-14
57. By undertaking the analysis in real terms, the financial manager avoids having to forecast
inflation.
True False
58. Do not forget to include interest and dividend payments when calculating the project's
cash flows.
True False
59. Depreciation acts as a tax shield in reducing the taxes.

True False
60. Working capital is one of the most common sources of mistakes in estimating project cash
flows.
True False
61. In the MACRS system of depreciation most industrial equipment fall into the ten- and
fifteen-year classes.
True False
62. All large U.S. corporations keep two separate sets of books, one for the stockholders and
one for the Internal Revenue Service.
True False
63. Equivalent annual cash flow approach can be used to determine the year in which the
existing machine can be profitably replaced with a new machine.
True False
6-15
64. The rule for comparing machines with different lines is to select the machine with the
greatest equivalent annual cost (EAC).
True False
65. You should replace a machine when the EAC of continuing to operate it exceeds the EAC
of the new machine.
True False
66. When evaluating a projects with positive NPV but variable life spans, the proper
technique to employ is the equivalent annual annuity (EAA) approach.
True False
67. Equivalent annual cash flows are used whenever the lives of projects are the same.
True False
Short Answer Questions
68. Define the term cash flow for a project.
6-16
69. What are some of the important points to remember while estimating the cash flows of a
project?
70. Briefly explain how inflation is treated consistently while estimation the project NPV.
71. Briefly explain the acronym MACRS.
72. Briefly discuss how taxes are taken into consideration in countries like Japan.
6-17
73. What are some of the additional factors that have to be considered while estimating cash
flows in other countries and currencies?
74. How do you compare projects with different lives?
75. Briefly explain how the decision to replace an existing machine is made?
76. Briefly explain how the cost of excess capacity is taken into consideration.
6-18
77. Briefly explain the difference between an equivalent annual cost and an equivalent annual
annuity.
6-19
Chapter 06 Making Investment Decisions with the Net Present Value Rule
Answer Key
Multiple Choice Questions
1. Important points to remember while estimating cash flows of projects are:

I) only cash flow is relevant
II) always estimate cash flows on an incremental basis
III) be consistent in the treatment of inflation
A. I only
B. I and II only
C. II, and III only
D. I,II, and III
Type: Easy
2. Preferably, cash flows for a project are estimated as:

A. Cash flows before taxes
B. Cash flows after taxes
C. Accounting profits before taxes
D. Accounting profits after taxes
Type: Medium
3. When a firm has the opportunity to add a project that will utilize excess factory capacity
(that is currently not being used), which costs should be used to determine if the added project
should be undertaken?
A. Opportunity cost
B. Sunk cost
C. Incremental costs
Type: Medium
6-20
4. A reduction in the sales of existing products caused by the introduction of a new product is
an example of:
A. incidental effects
B. opportunity cost
C. sunk cost
Type: Easy
5. For example, when Honda develops a new engine, the incidental effects might include the
following:
I) demand for replacement parts
II) profitable service facilities
III) offer modified or improved versions of the engine for other uses
A. I only
B. I and II only
C. I,II, and III
D. None of the given ones
Type: Medium
6. The cost of a resource that may be relevant to an investment decision even when no cash
changes hand is called a (an):
A. Sunk cost
B. Opportunity cost
C. Working capital
Type: Difficult
6-21
7. Net Working Capital is the:

I) short-term assets
II) short term liabilities
III) long-term assets
IV) long term liabilities
A. I only
B. (I - II)
C. (III - I)
D. (III - IV)
Type: Medium
8. Investment in net working capital is not depreciated because:

A. It is not a cash flow
B. It is recovered during or at the end of the project and is not a depreciating asset
C. It is a sunk cost
D. All of the above
Type: Medium
9. Net Working Capital should be considered in project cash flows because:

A. Firms must invest cash in short-term assets to produce finished goods
B. They are sunk costs
C. Firms need positive NPV projects for investment
Type: Medium
6-22
10. Investment in inventories includes investment in:

I) Raw material
II) Work-in-progress
III) Finished goods
A. I only
B. I and II only
C. I, II, and III
D. III only
Type: Easy
11. For example, in case of an electric car project, the following cash flows should be treated
as incremental flows when deciding whether to go ahead with the project except:
A. The consequent reduction in sales of the company's existing gasoline models (i.e.:
incidental effects)
B. Interest payment on debt
C. The value of tools that can be transferred from the company's existing plants
D. The expenditure on new plants and equipment
Type: Medium
12. The principal short-term assets are:

I) Cash, II) Accounts receivable, III) Inventories, and IV) Accounts Payable
A. I only
B. I and IV only
C. I, II, and III
D. IV only
Type: Easy
6-23
13. The value of a previously purchased machine to be used by a proposed project is an

example of:
A. Sunk cost
B. Opportunity cost
C. Fixed cost
Type: Medium
14. Money that a firm has already spent or committed to spend regardless of whether a project
is taken is called:
A. Fixed cost
B. Opportunity cost
C. Sunk cost
Type: Medium
15. The cost that is incurred as a result of past, irrevocable decisions and is irrelevant to future
decisions is called:
A. Opportunity cost
B. Sunk cost
C. Incremental cost
Type: Medium
16. For example, in the case of an electric car project, which of the following cash flows
should be treated as incremental flows when deciding whether to go ahead with the project?
A. The cost of research and development undertaken for developing the electric car in the past
three years
B. The annual depreciation charge
C. Tax savings resulting from the depreciation charges
D. Dividend payments
Type: Difficult
6-24
17. In the case of freely traded resources, opportunity cost is the:

A. book value
B. market value
C. historical value
Type: Medium
18. If the discount rate is stated in nominal terms, then in order to calculate the NPV in a
A. I only
B. II only
C. III only
Type: Medium
19. If the discount rate is stated in real terms, then in order to calculate the NPV in a
A. I only
B. II only
C. III only
Type: Medium
6-25
20. A firm owns a building with a book value of $150,000 and a market value of $250,000. If
the building is utilized for a project, then the opportunity cost ignoring taxes is:
A. $100,000
B. $150,000
C. $250,000
Type: Medium
21. The real interest rate is 3% and the inflation rate is 5%. What is the nominal interest rate?
A. 3%
B. 5%
C. 8.15%
D. 2%
1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815)

Nominal rate = 0.0815 = 8.15%
Type: Easy
22. If the nominal interest rate is 7. 5% and the inflation rate is 4%, what is the real interest
rate?
A. 4%
B. 9.5%
C. 3.4%
1 + real rate = (1 + nominal rate) / (1 + inflation rate) = 1.075/1.04 = 1.0337;

real rate = 3.4%
Type: Easy
6-26
23. A cash flow received in two years is expected to be $10,816 in nominal terms. If the real
rate of interest is 2% and the inflation rate is 4%, what is the real cash flow for year-2?
A. $11,236
B. $10,816
C. $10,000
D. $9,246
Real cash flow = 10,816/(1.04^2) = 10,000
Type: Medium
A. $51.70
B. $35.54
C. $45.21
NPV = -200 + 150/1.05 + 120/(1.05^2) = 51.70
Type: Difficult
6-27
A. $25.85
B. $17.77
C. $22.65
NPV = -100 + 75/1.1 + 60/(1.1^2) = 17.77
Type: Difficult
26. The real rate of interest is 3% and the inflation is 4%. What is the nominal rate of
interest?
A. 3%
B. 4%
C. 7.12%
D. 1%
1 + nominal rate = 1.03 * 1.04 = 1.0712; nominal rate = 7.12%
Type: Easy
6-28
27. The NPV value obtained by discounting nominal cash flows using the nominal discount
rate is the:
I) same as the NPV value obtained by discounting real cash flows using the real discount rate
II) same as the NPV value obtained by discounting real cash flows using the nominal discount
rate
III) same as the NPV value obtained by discounting nominal cash flows using the real
discount rate
A. I only
B. II only
C. III only
D. II and III only
Type: Medium
28. Real cash flow occurring in year-2 is $60,000. If the inflation rate is 5% per year, the real
rate of interest is 2%, calculate the cash flow for the year-2.
A. $60,000
B. $55,422
C. $66,150
Nominal cash flow = (60,000)(1.05)^2 = 66,150
Type: Medium
29. Proper treatment of inflation in the NPV calculation involves:

I) Discounting nominal cash flows using the nominal discount rate
II) Discounting real cash flows using the real discount rate
III) Discounting nominal cash flows using the real discount rates
A. I only
B. II only
C. III only
D. I and II only
Type: Medium
6-29
30. A firm has a general-purpose machine, which has a book value of $300,000 and is sold for
$500,000 in the market. If the tax rate is 35%, what is the opportunity cost of using the
machine in a project?
A. $500,000
B. $430,000
C. $300,000
500,000 - (500,000 - 300,000) * 0.35 = 430,000
Type: Difficult
31. Capital equipment costing $250,000 today has 50,000 salvage value at the end of 5 years.
If the straight line depreciation method is used, what is the book value of the equipment at the
end of two years?
A. $200,000
B. $170,000
C. $140,000
D. $50,000
Annual depreciation = (250,000 - 50,000)/5 = 40,000

Book value at the end of two years = 250,000 - 80,000 = 170,000
Type: Medium
32. A capital equipment costing $400,000 today has no (zero) salvage value at the end of 5
years. If straight-line depreciation is used, what is the book value of the equipment at the end
of three years?
A. $120,000
B. $80,000
C. $160,000
D. $240,000
Annual depreciation = $400,000/5 = 80,000

Depreciation for 3 years = 240,000
Book value = 400,000 - 240,000 = 160,000
Type: Medium
6-30
33. For project Z, year-5 inventories increase by $6,000, accounts receivables by $4,000 and
accounts payables by $3,000. Calculate the increase or decrease in working capital for year-5.
A. Increases by $6,000
B. Decreases by $4,000
C. Increases by $7,000
D. Decreases by $7,000
Working capital: 6000 + 4000 - 3000 = 7,000
Type: Medium
34. For project A in year-2, inventories increase by $12,000 and accounts payable by $2,000.
Calculate the increase or decrease in net working capital for year-2.
A. Decreases by $14,000
B. Increases by $14,000
C. Decreases by $10,000
D. Increases by $10,000
Working capital = 12,000 - 2000 = + 10,000
Type: Medium
35. Working capital is one of the most common causes of misunderstanding in estimating
project cash flows. The following are the most common errors:
I) forgetting about working capital entirely
II) forgetting that working capital may change during the life of the project
III) forgetting that working capital is recovered at the end of the project
IV) forgetting to depreciate the working capital
A. I and II only
B. I, II, and III only
C. II,III and IV only
D. I,II and IV only
Type: Difficult
6-31
36. If the depreciation amount is 600,000 and the marginal tax rate is 35%, then the tax shield
due to depreciation is:
A. $210,000
B. $600,000
C. $390,000
Tax shield effect = (600,000)(0.35) = 210,000
Type: Easy
37. If the depreciation amount is $100,000 and the marginal tax rate is 35%, then the tax
shield due to depreciation is:
A. $35,000
B. $100,000
C. $65,000
Tax shield effect = (100,000)(0.35) = 35,000
Type: Easy
38. If the depreciable investment is $600,000 and the MACRS 5-Year class schedule is:
Calculate the depreciation for Year-2.
A. $120,000
B. $192,000
C. $96,000
D. $115,200
Depreciation for Year-2 = (600,000)(0.32) = 192,000
Type: Easy
6-32
39. If the depreciable investment is $1,000,000 and the MACRS 5-Year class schedule is:
Calculate the depreciation tax shield for Year-2 using a tax rate of 30%:
A. $224,000
B. $60,000
C. $96,000
D. $300,000
Depreciation = (1,000,000)(0.32)(0.3) = 96,000
Type: Easy
Assume that the asset can be sold for book value. Calculate the NPV of the project:
(Approximately)
A. $22,463
B. $19,315
C. $16,244
-200,000 + (103,800/1.12) + ((111,000 + 44,000)/(1.12^2)) = $16,244
Type: Difficult
6-33
Assume that the asset can be sold for book value. Calculate the IRR for the project:
(approximately)
A. 12.00%
B. 11.00%
C. 17.73%
0 = -200,000 + (103,800/(1 + IRR)) + (155,000/((1 + IRR)^2)) = 17.73%
Type: Difficult
42. You have been asked to evaluate a project with infinite life. Sales and costs are projected
to be $1000 and $500 respectively. There is no depreciation and the tax rate is 30%. The real
required rate of return is 10%. The inflation rate is 4% and is expected to be 4% forever. Sales
and costs will increase at the rate of inflation. If the project costs $3000, what is the NPV?
A. $500.00
B. $1629.62
C. $365.38
NPV = [((1000/1.04) - (500/1.04)) (0.7)] / 0.1 - (3000 ) = $365.38
Type: Difficult
6-34
43. A project requires an investment of $900 today. It has sales of $1,100 per year forever.
Costs will be $600 the first year and increase by 20% per year. Ignoring taxes calculate the
NPV of the project at 12% discount rate.
A. $65.00
B. $57.51
C. $100.00
D. Cannot be calculated as g > r
NPV = -900 + (1,100 - 600)/1.12 + (1,100 - (600 * 1.2))/(1.12^2) +

(1,100 - 600 (1.2^2))/(1.12)^3 + (1,100 - 600 (1.2^3))/(1.12^4) = $57.51.
(The project is stopped when costs> revenues)
Type: Difficult
44. Which of the following countries allow firms to keep two separate sets of books, one for
the stockholders and one for the tax authorities like the Internal Revenue Service?
I) U.S.A., II) Japan, and III) France
A. I only
B. I and II only
C. I, II, and III only
Type: Easy
45. Germany allows firms to choose the following depreciation methods:

I) Straight-line method, and II) Declining-balance method
A. I only
B. II only
C. I and II only
D. Germany allows a totally different system
Type: Easy
6-35
46. Two machines, A and B, which perform the same functions, have the following costs and
lives.
Which machine would you choose? The two machines are mutually exclusive and the cost of
capital is 15%.
A. Machine A as the EAC is $1789.89
B. Machine B as the EAC is $1922.88
C. Don't buy either machine
D. Accept both A and B
EAC(A) = 6,000/3.35215 = 1789.89

EAC(B) = 8000/4.1604 = 1922.88
Type: Difficult
47. Two mutually exclusive projects have the following NPVs and project lives.
If the cost of capital is 15%, which project would you accept?

A. A
B. B
C. Both A and B
D. Reject both A and B
EAC(A) = 5000/2.2832 = 2189.88 (Accept the project with higher EAC)

EAC(B) = 6500/3.35216 = 1939.05
Type: Difficult
6-36
48. OM Construction Company must choose between two types of cranes. Crane A costs
$600,000, will last for 5 years, and will require $60,000 in maintenance each year. Crane B
costs $750,000 and will last for seven years and will require $30,000 in maintenance each
year. Maintenance costs for cranes A and B are incurred at the end of each year. The
appropriate discount rate is 12% per year. Which machine should OM Construction
purchase?
A. Crane A as EAC is $226,444
B. Crane B as EAC is $194,336
C. Crane A as the PV is $816,286
D. Cannot be calculated as the revenues for the project are not given
PV (A) = 600,000 + 60,000 (3.6048) = 816,286

EAC = 816,286/(3.6048) = $226,444
PV(B) = 750,000 + 30, 000 (4.5638) = 886,913
EAC = 886,913/(4.5638) = $194,336.45 (Accept the project with least annual cost)
Type: Difficult
49. You are considering the purchase of one of two machines required in your production
process. Machine A has a life of two years. Machine A costs $50 initially and then $70 per
year in maintenance. Machine B has an initial cost of $90. It requires $40 in maintenance for
each year of its 3 year life. Either machine must be replaced at the end of its life. Which is the
better machine for the firm? The discount rate is 15% and the tax rate is zero.
A. Machine A as EAC for Machine A is $100.76
B. Machine B as EAC for Machine B is $79.42
C. Machine A as PV of costs for Machine A is $163.80
D. Machine B as PV of costs for Machine B is $181.33
Costs: PV(A) = 50 + 70/1.15 + 70/(1.15^2) = 163.80; EAC = 163.80/(1.6257) = 100.76

PV(B) = 90 + 40/1.15 + 40/(1.15^2) + 40/(1.15^3) = 181.33; EAC = 181.33/2.2832 = 79.42
(Accept the project with least annual cost)
Type: Difficult
6-37
50. RainMan Inc. is in the business of producing rain upon request. They must decide
between two investment projects; a new airplane for seeding rain clouds or a new weather
control machine built by Dr. Nutzbaum. The discount rate for the new airplane is 9%, while
the discount rate for the weather machine is 39% (it happens to be higher risk). Which
investment should the company select and why?
A. Airplane because is has a higher NPV

B. Weather machine because is has a higher NPV
C. Airplane because is has a higher annuity
D. Weather machine because is has a higher annuity
NPV of the airplane is 63.72 and the EAA of the airplane is 36.22
NPV of the weather machine is 61.29 and the EAA of the machine is 38.08
Since they have different life spans the weather machine has a higher EAA and should be
accepted.
Type: Difficult
51. Using the technique of equivalent annual cash flows and a discount rate of 7%, what is the
value of the following project?
A. 3.06
B. 3.61
C. 10.25
D. 12.23
NPV of the project is 12.23 and the EAA of the airplane is 3.61
Type: Medium
True / False Questions
6-38
52. When calculating cash flows, it is important to consider them on an incremental basis.
TRUE
Type: Easy
53. When calculating cash flows, it is important to consider all incidental effects.
TRUE
Type: Easy
54. Opportunity costs should not be included as they are missed opportunities.
FALSE
Type: Medium
55. Working capital is needed additional investment in the project and should considered for
cash flow estimation.
TRUE
Type: Medium
56. Sunk costs are bygones, they are unaffected by the decision to accept or reject and should
be ignored.
TRUE
Type: Easy
57. By undertaking the analysis in real terms, the financial manager avoids having to forecast
inflation.
FALSE
Type: Medium
6-39
58. Do not forget to include interest and dividend payments when calculating the project's
cash flows.
FALSE
Type: Medium
59. Depreciation acts as a tax shield in reducing the taxes.

TRUE
Type: Medium
60. Working capital is one of the most common sources of mistakes in estimating project cash
flows.
TRUE
Type: Medium
61. In the MACRS system of depreciation most industrial equipment fall into the ten- and
fifteen-year classes.
FALSE
Type: Difficult
62. All large U.S. corporations keep two separate sets of books, one for the stockholders and
one for the Internal Revenue Service.
TRUE
Type: Difficult
6-40
63. Equivalent annual cash flow approach can be used to determine the year in which the
existing machine can be profitably replaced with a new machine.
TRUE
Type: Medium
64. The rule for comparing machines with different lines is to select the machine with the
greatest equivalent annual cost (EAC).
FALSE
Type: Medium
65. You should replace a machine when the EAC of continuing to operate it exceeds the EAC
of the new machine.
TRUE
Type: Difficult
66. When evaluating a projects with positive NPV but variable life spans, the proper
technique to employ is the equivalent annual annuity (EAA) approach.
TRUE
Type: Difficult
67. Equivalent annual cash flows are used whenever the lives of projects are the same.
FALSE
Type: Difficult
Short Answer Questions
6-41
68. Define the term cash flow for a project.
Cash flow for a project is the net income plus depreciation. Cash flows are always estimated
on an after-tax basis.
Type: Easy
69. What are some of the important points to remember while estimating the cash flows of a
project?
 Estimate after-tax cash flows on an incremental basis.

 Include all incidental effects.
 Include working capital requirements.
 Include opportunity costs.
 Do not include sunk costs.
 Take inflation into consideration in a consistent manner.
Type: Medium
70. Briefly explain how inflation is treated consistently while estimation the project NPV.
There are two ways to treat inflation consistently in the estimation of NPV of a project. If the
discount rate is stated in nominal terms, then consistency requires that project cash flows also
be estimated in nominal terms. This might involve using different inflation rates for different
components of cash flow. If the discount rate is stated in real terms then real cash flows are
estimated for the project. The consistency rule is: discount nominal cash flows at a nominal
discount rate and discount real cash flows at a real discount rate.
Type: Medium
6-42
71. Briefly explain the acronym MACRS.
MACRS is short for Modified Accelerated Cost Recovery System. This is the result of the
Tax Reform Act of 1986. It is based on a combination of double declining method and
straight line depreciation methods. In this system, assets are classified into several classes like
3-year class, 5-year class etc. Tax depreciation allowed under each asset class is provided in a
Table format. It uses mid-year convention and hence an asset under 3-year class has
depreciation for four years, and etc. The alternative is to use the straight-line depreciation
method.
Type: Medium
72. Briefly discuss how taxes are taken into consideration in countries like Japan.
In Japan and all of the European Community countries, it is not possible to separate tax
accounts reported to the government and those reported to shareholders. They must be same.
In some countries it is not possible to use the accelerated depreciation.
Type: Medium
73. What are some of the additional factors that have to be considered while estimating cash
flows in other countries and currencies?
 Currency of the cash flow should be relevant to the project

 Use an appropriate inflation rate for the project
 Use the relevant tax rate and depreciation method for the project
 Use the appropriate discount rate for the project
Type: Medium
6-43
74. How do you compare projects with different lives?
Projects with different lives are compared assuming that the projects are repeated to infinity,
called replacement chains. The replacement chains are analyzed using equivalent annual costs
(EAC) or adjusted NPVs (adjusted for differences in project lives).
Type: Difficult
75. Briefly explain how the decision to replace an existing machine is made?
The decision to replace an existing machine is done for economic or technological reasons or
for both. For this equivalent annuity approach is used. As long as the benefits exceed
equivalent annual costs replacing old machine with a new one, the decision will be a sound
one.
Type: Difficult
76. Briefly explain how the cost of excess capacity is taken into consideration.
Many managers assume that the marginal cost of excess capacity is zero and encourage
employees to use up the excess capacity. This may not be a very sound way to utilize excess
capacity. If we use the equivalent annual cost (EAC) approach cost of excess capacity can be
estimated easily. Indiscriminate use of excess capacity may result in replacing the existing
machine with a new machine sooner. This is the cost of excess capacity and must be taken
into consideration.
Type: Difficult
6-44
77. Briefly explain the difference between an equivalent annual cost and an equivalent annual
annuity.
The technique of equivalent annual cash flows can be employed for evaluating cost saving
projects or projects that generate positive NPVs. When used to evaluate cost savings projects
the term equivalent annual cost is used and we seek to minimize this number. When looking
at positive NPV projects the term equivalent annual annuity is used and we seek to maximize
this number.
Type: Difficult
6-45

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Chap 006

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Chapter 06 - Making Investment Decisions with the Net Present Value Rule

Multiple Choice Questions

1. Important points to remember while estimating cash flows of projects are:

2. Preferably, cash flows for a project are estimated as:

7. Net Working Capital is the:

8. Investment in net working capital is not depreciated because:

9. Net Working Capital should be considered in project cash flows because:

10. Investment in inventories includes investment in:

12. The principal short-term assets are:

13. The value of a previously purchased machine to be used by a proposed project is an

17. In the case of freely traded resources, opportunity cost is the:

24. Given the following data for Project M:

25. Given the following data for Project M:

29. Proper treatment of inflation in the NPV calculation involves:

45. Germany allows firms to choose the following depreciation methods:

If the cost of capital is 15%, which project would you accept?

A. Airplane because is has a higher NPV

True / False Questions

59. Depreciation acts as a tax shield in reducing the taxes.

Short Answer Questions

68. Define the term cash flow for a project.

71. Briefly explain the acronym MACRS.

74. How do you compare projects with different lives?

Multiple Choice Questions

1. Important points to remember while estimating cash flows of projects are:

2. Preferably, cash flows for a project are estimated as:

7. Net Working Capital is the:

8. Investment in net working capital is not depreciated because:

9. Net Working Capital should be considered in project cash flows because:

10. Investment in inventories includes investment in:

12. The principal short-term assets are:

13. The value of a previously purchased machine to be used by a proposed project is an

17. In the case of freely traded resources, opportunity cost is the:

1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815)

1 + real rate = (1 + nominal rate) / (1 + inflation rate) = 1.075/1.04 = 1.0337;

Real cash flow = 10,816/(1.04^2) = 10,000

24. Given the following data for Project M:

NPV = -200 + 150/1.05 + 120/(1.05^2) = 51.70

25. Given the following data for Project M:

NPV = -100 + 75/1.1 + 60/(1.1^2) = 17.77

1 + nominal rate = 1.03 * 1.04 = 1.0712; nominal rate = 7.12%

Nominal cash flow = (60,000)(1.05)^2 = 66,150

29. Proper treatment of inflation in the NPV calculation involves:

500,000 - (500,000 - 300,000) * 0.35 = 430,000

Annual depreciation = (250,000 - 50,000)/5 = 40,000

Annual depreciation = $400,000/5 = 80,000

Working capital: 6000 + 4000 - 3000 = 7,000

Working capital = 12,000 - 2000 = + 10,000

Tax shield effect = (600,000)(0.35) = 210,000

Tax shield effect = (100,000)(0.35) = 35,000

Depreciation for Year-2 = (600,000)(0.32) = 192,000

Depreciation = (1,000,000)(0.32)(0.3) = 96,000

-200,000 + (103,800/1.12) + ((111,000 + 44,000)/(1.12^2)) = $16,244

0 = -200,000 + (103,800/(1 + IRR)) + (155,000/((1 + IRR)^2)) = 17.73%

NPV = [((1000/1.04) - (500/1.04)) (0.7)] / 0.1 - (3000 ) = $365.38

NPV = -900 + (1,100 - 600)/1.12 + (1,100 - (600 * 1.2))/(1.12^2) +

45. Germany allows firms to choose the following depreciation methods:

EAC(A) = 6,000/3.35215 = 1789.89

If the cost of capital is 15%, which project would you accept?

EAC(A) = 5000/2.2832 = 2189.88 (Accept the project with higher EAC)

PV (A) = 600,000 + 60,000 (3.6048) = 816,286

Costs: PV(A) = 50 + 70/1.15 + 70/(1.15^2) = 163.80; EAC = 163.80/(1.6257) = 100.76

A. Airplane because is has a higher NPV