CHAPTER 7 Making Capital Investment Decisions

Multiple Choice Questions: II. CONCEPTS

PRO FORMA INCOME STATEMENT 12. The pro forma income statement for a cost reduction project: a. will reflect a reduction in the sales of the firm. b. will generally reflect no incremental sales. c. has to be prepared reflecting the total sales and expenses of a firm. d. cannot be prepared due to the lack of any project related sales. e. will always reflect a negative project operating cash flow. Difficulty level: Easy

INCREMENTAL CASH FLOW 13. One purpose of identifying all of the incremental cash flows related to a proposed project is to: a. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm. b. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project. c. make each project appear as profitable as possible for the firm. d. include both the proposed and the current operations of a firm in the analysis of the project. e. identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis Difficulty level: Medium SUNK COST 15. Sunk costs include any cost that: a. will change if a project is undertaken. b. will be incurred if a project is accepted. c. has previously been incurred and cannot be changed. d. is paid to a third party and cannot be refunded for any reason whatsoever. e. will occur if a project is accepted and once incurred, cannot be recouped. Difficulty level: Easy EROSION 17. Erosion can be explained as the: a. additional income generated from the sales of a newly added product. b. loss of current sales due to a new project being implemented.


All of the following are anticipated effects of a proposed project. loss of revenue due to customer theft. III. Which of these should be included in the initial project cash flow related to net working capital? I. Difficulty level: Easy TYPES OF COSTS 19. I and II only b. loss of revenue due to employee theft. II. II and IV only d. Which of the following should be included in the analysis of a project? I. an inventory decrease of $5. I. sunk costs II. an increase in accounts receivable of $1. and IV only e. loss of cash due to the expenses required to fix a parking lot after a heavy rain storm. and IV only e. e. II and IV only d. erosion costs IV. d. I. II. Net working capital: 7-2 . incremental costs a. III and IV only c. and IV Difficulty level: Medium NET WORKING CAPITAL 23. I and II only b.500 III.100 a. opportunity costs III. an increase in fixed assets of $7.c.600 IV. III. a decrease in accounts payable of $2.000 II. and IV only Difficulty level: Medium NET WORKING CAPITAL 20. II. I. I and III only c. II.

amount of tax saved annually due to the depreciation expense. e. cannot expense any of the cost of a new asset during the first year of the asset’s life. A company which uses the MACRS system of depreciation: will have equal depreciation costs each year of an asset’s life. Difficulty level: Easy MACRS 24. The book value of an asset is primarily used to compute the: a.a. e. c. create a cash inflow at the beginning of a project. is frequently affected by the additional sales generated by a new project. b. d. requirements generally. annual depreciation tax shield. is the only expenditure where at least a partial recovery can be made at the end of a project. can depreciate the cost of land. d. but not always. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. expenditures commonly occur at the end of a project. will expense the cost of nonresidential real estate over a period of 7 years. a. b. will write off the entire cost of an asset over the asset’s class life. e. amount of tax due on the sale of an asset. Difficulty level: Easy BOOK VALUE 27. change in depreciation needed to reflect the market value of the asset. amount of cash received from the sale of an asset. if it so desires. c. b. c. Difficulty level: Easy 7-3 . d.

The cash flows of a project should: a. the sales projections are lowered. the project is a cost-cutting project. The salvage value of an asset creates an after-tax cash inflow to the firm in an amount equal to the: a. e. the earnings before interest and taxes decreases. be applied to the year when the related expense or income is recognized by GAAP. e. including opportunity costs. The bottom-up approach to computing the operating cash flow applies only when: a. the interest expense is lowered. the depreciation expense increases. d. be computed on a pre-tax basis. Difficulty level: Easy BOTTOM-UP OCF 33. sales price plus the tax due based on the book value minus the sales price. sales price plus the tax due based on the sales price minus the book value. include all incremental costs. d. d. both the depreciation expense and the interest expense are equal to zero. c. b. sales price of the asset. b. c. b. c. the net working capital requirement increases. include all sunk costs and opportunity costs. e. c. the interest expense is equal to zero.SALVAGE VALUE 28. Difficulty level: Easy PROJECT OCF 30. b. Difficulty level: Easy PROJECT CASH FLOWS 31. sales price minus the tax due based on the sales price minus the book value. include all financing costs related to new debt acquired to finance the project. sales price minus the book value. 7-4 . A project’s operating cash flow will increase when: a.

differing machine lives. both net present value and the internal rate of return. $1. their effective annual costs. equipment depreciation e.2 million. revenue-generating Difficulty level: Easy EQUIVALENT ANNUAL COST 38. e. revenue-cutting e. Marshall’s & Co. employee salaries b. The building cost is estimated at $1. Difficulty level: Medium III. A project which is designed to improve the manufacturing efficiency of a firm but will generate no additional sales is referred to as a(n) _____ project. PROBLEMS RELEVANT CASH FLOWS 40. $1.000 c.000. The company now wants to build a new retail store on the site. taxes are ignored and the interest expense is equal to zero. sunk cost b. a. The machines sell for differing prices. c. no fixed assets are required for the project. d.000 b. the company spent $50. office rent c. Toni’s Tools is comparing machines to determine which one to purchase.000 7-5 .000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking.000. These machines should be compared using: a. have differing operating costs. opportunity c. At the time of the purchase. The lot was recently appraised at $810. e. purchased a corner lot in Eglon City five years ago at a cost of $640. and will be replaced when worn out. the replacement parts approach. What amount should be used as the initial cash flow for this building project? a.840. $1.d. cost-cutting d.200. An increase in which one of the following will increase the operating cash flow? a. equipment rental Difficulty level: Easy COST-CUTTING 37. b.890. net present value only. the depreciation tax shield approach. building maintenance d.000 to grade the lot and another $4. Difficulty level: Medium TAX SHIELD 35.

000 d.000 e.000 and a market value of $295.000 Difficulty level: Easy 7-6 .000 e. if any. repairs were made to the building which cost $60.000 c. $295. $857. $515. sells customized shoes. it sells 10. It is considering adding a lower-priced line of shoes which sell for $49 a pair. Walks Softly estimates it can sell 5.000. Walks Softly. $2. $177. e. What is the amount of the sales that should be used when evaluating the addition of the lower-priced shoes? a.000.000 pairs of shoes annually at an average price of $68 a pair. $268.000 Difficulty level: Medium RELEVANT CASH FLOWS 43.000 c.000 six years ago.d.000 $2.000 b. $0 b.000.000 less pairs of the higher-priced shoes by doing so.060.000 Difficulty level: Medium OPPORTUNITY COST 44. The annual taxes on the property are $20. The warehouse has a current book value of $268. Four years ago. Inc.000 pairs of the lower-priced shoes but will sell 1. Your firm purchased a warehouse for $335. If the company decides to assign this warehouse to a new project. $395. Currently. should be included in the initial cash flow of the project for this building? a. $789. $245. $313.010.000 d. what value. The warehouse is totally paid for and solely owned by your firm.

150.000.300 b. The project will cost $150. $13.900. However.000 each. $118. and 4. $8.789.500 and the pop-ups sell for $5.EROSION COST 47. What is the erosion cost? a. $3.000 d. Jamie’s Motor Home Sales currently sells 1. Ernie’s Electrical is evaluating a project which will increase sales by $50.000 c.000 pop-up trailers each year.500 of them. 2. Class A motor homes sell for an average of $125. Jamie is considering adding a mid-range camper and expects that if she does so she can sell 1. Class C homes are priced at $39.000 and a profit margin of 5%.000 and be depreciated straight-line to a zero book value over the 10 year life of the project. Jamie expects that her Class A sales will decline to 950 units while the Class C campers decline to 2. $6.500 Difficulty level: Medium OCF 48.000.000 Class A motor homes. What is the operating cash flow for this project? a. $93. What is the amount of the operating cash flow if the company has no long-term debt? a.000 and costs by $30.300 Difficulty level: Medium BOTTOM-UP OCF 50.500 Class C motor homes. The applicable tax rate is 34%.300 d. $34.400 c.400 e. $120.000 e.000 c. The annual depreciation expense is $80.000 each.900 7-7 .750. Peter’s Boats has sales of $760.100. $18.250. $118.200.000 b.300 e. $86. $5.000 d. The sales of pop-ups will not be affected. if the new camper is added. $53.000 b. The new mid-range camper will sell for $47. $123. $18.

000 and increase cash expenses by $10.500 Difficulty level: Medium TAX SHIELD OCF 54. $5.000. $6.000 e. $4. What is the amount of the depreciation expense for the third year? MACRS 5-year property Year Rate 1 20. What is the value of the depreciation tax shield? a.000. $8. $10. A project will increase sales by $140.350 Difficulty level: Medium DEPRECIATION TAX SHIELD 55. A project will increase sales by $60.000 and cash expenses by $51. Sun Lee’s Furniture just purchased some fixed assets classified as 5-year property for MACRS.000 to $24. $37. $22. The company has a marginal tax rate of 34%.00% 3 19.20% 7-8 . The project will cost $100. $8. $7. $9. Ben’s Border Café is considering a project which will produce sales of $16. $4.000 and cash expenses by $95.000 to $5. The project will cost $40. What is the operating cash flow of the project using the tax shield approach? a.500 e.000 and be depreciated using the straight-line method to a zero book value over the 4year life of the project.500 c.500 b. $17.Difficulty level: Medium TOP-DOWN OCF 52.000 and be depreciated using straight-line depreciation to a zero book value over the 4year life of the project.000 d.350 d.000 b.00% 2 32.650 c. $8.000.750 Difficulty level: Medium MACRS DEPRECIATION 56. taxes will increase from $23.500 d. $25. The assets cost $24. What is the amount of the operating cash flow using the top-down approach? a.000 c. The company has a marginal tax rate of 35%.850 b.700 e. If the project is implemented.500. $9.000.500 and depreciation will increase from $4.

500.304 $2. d.000.52% 5 11.880. The taxable amount on the sale is $38. The book value today is $8.76% The tax due on the sale is $14.00% 2 32. The equipment is 5-year property for MACRS. You are considering selling the equipment today for $82.4 5 6 a. $2. e. b. You will receive a tax refund of $13. a.800 11. c. Which one of the following statements is correct if your tax rate is 34%? MACRS 5-year property Year Rate 1 20.765 $4. c. d.320.52% 5.00% 3 19. You own some equipment which you purchased three years ago at a cost of $135.52% 11.219. Difficulty level: Medium 7-9 . b.52% 6 5.76% Difficulty level: Easy SALVAGE VALUE 60.830.608 $4.20% 4 11.478.80. The book value today is $64. e.507 $2.20 as a result of this sale.

$5.17 Difficulty level: Medium COST-CUTTING 66.600 Difficulty level: Medium EQUIVALENT ANNUAL COST 69. The system will cost $48. These assets will be worthless at the end of the project. $1. $1. $2.11 b.000.000 a year to 7-10 .000. An additional $3.500 a year for three years. The initial cost of the fixed assets is $50.09 d. A project is expected to create operating cash flows of $22. What is the amount of the earnings before interest and taxes for this project? a.208. $4. -$9.000. $2. This machine costs $10.400 d.954. The initial cost of one customized tool and die machine is $850.000 of net working capital will be required throughout the life of the project. Matty’s Place is considering the installation of a new computer system that will cut annual operating costs by $11.000 e.600 b. This system is expected to have a 5-year life and will be depreciated to zero using straight-line depreciation.306.PROJECT NPV 63.17 c. What is the project’s net present value if the required rate of return is 10%? a. Inc. $11.11 e.954.208. $5.000 c. $20. Tool Makers. uses tool and die machines to produce equipment for other firms.000 to purchase and install.

000 b. d.000 d.78: Margarite’s Enterprises is considering a new project. $99. The project will require $325.000 and are expected to increase by 10% if this project is accepted. e. $136. b. At the end of the project.000. the fixed assets can be 7-11 . What is the initial project cash flow needed for net working capital? a. $75. operate. What is the equivalent annual cost of this machine if the required return is 9%? (Round your answer to whole dollars.000 for new fixed assets.000 for additional accounts receivable.) $325.a.000 and will also increase accounts payable by $45.002 $345. The project has a 5-year life.000 for additional inventory and $35.000 as suppliers are willing to finance part of these purchases. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. $91. Kay’s Nautique is considering a project which will require additional inventory of $128. c.000 e. Accounts receivable are currently $80.000 and long-term debt is expected to increase by $300. $160.619 Difficulty level: Challenge NET WORKING CAPITAL 72. $181.797 $347.000 Difficulty level: Medium The following information should be used for problems #75 . Short-term debt is expected to increase by $100.000 c. Each machine has a life of 3 years before it is replaced.797 $340.648 $351.

813 d.000 b.000 Difficulty level: Medium AFTER-TAX SALVAGE VALUE 77.000 c.009 e. e.) a. a.000 d. d.500 $159.000 e. What is the amount of the earnings before interest and taxes for the first year of this project? $38. $325. $37.500 $59. $620. $425.250 Difficulty level: Medium 7-12 .918 c. The tax rate is 35% and the required rate of return is 15%.000.000 Difficulty level: Medium EBIT 76.000 $76.438 b. b. What is the amount of the after-tax cash flow from the sale of the fixed assets at the end of this project? (Round your answer to whole dollars. $28. What is the initial cost of this project? a. $520.sold for 25% of their original cost. The project is expected to generate annual sales of $554. RELEVANT COSTS 75. $52. The net working capital returns to its original level at the end of the project.000 and costs of $430. $420.000 $67. c. $81. $60.