CAPITALBUDGETINGDECISIONS

MultipleChoice

c1.Whichofthefollowinggroupsofcapitalbudgetingtechniquesusesthe
timevalueofmoney?
a.Bookrateofreturn,payback,andprofitabilityindex.
b.IRR,payback,andNPV.
c.IRR,NPV,andprofitabilityindex.
d.IRR,bookrateofreturn,andprofitabilityindex.

b2.Discountedcashflowtechniquesforanalyzingcapitalbudgeting
decisionsareNOTnormallyappliedtoprojects
a.requiringnoinvestmentafterthefirstyearoflife.
b.havingusefullivesshorterthanoneyear.
c.thatareessentialtothebusiness.
d.involvingreplacementofexistingassets.

d3.Theprofitabilityindex
a.doesnotusepresentvaluesofcashflows.
b.isgenerallypreferabletoanyotherapproachforevaluatingmutually
exclusiveinvestmentalternatives.
c.producesthesamerankingofinvestmentalternativesasdoestheIRR
criterion.
d.isadiscountedcashflowmethod.

a4.CompaniesusingMACRSfortaxpurposesandstraightlinedepreciation
forfinancialreportingpurposesusuallyfindthattherelationship
betweenthetaxbasisandbookvalueoftheirassetsis
a.thetaxbasisislowerthanbookvalue.
b.thetaxbasisishigherthanbookvalue.
c.thetaxbasisisthesameasbookvalue.
d.noneoftheabove.

c5.AcompanythatwantstouseMACRSfortaxpurposesmust
a.requestpermissionfromtheIRS.
b.acquirenewassetsatornearthemiddleoftheyear.
c.ignoresalvagevalueincalculatingdepreciation.
d.dononeoftheabove.

c6.Thegovernmentcouldencourageincreasesininvestmentby
a.increasingtaxrates.
b.lengtheningtheMACRSperiods.
c.lettingacompanyexpensefixedassetsintheyearacquiredinstead
ofthroughannualdepreciationcharges.
d.takingactionsthatwouldincreaseinterestrates.

103
a7.Inchoosingfromamongmutuallyexclusiveinvestmentsthemanagershould
normallyselecttheonewiththehighest
a.NPV.
b.IRR.
c.profitabilityindex.
d.bookrateofreturn.

a8.Indecidingwhethertoreplaceamachine,whichofthefollowingisNOT
asunkcost?
a.Theexpectedresalepriceoftheexistingmachine.
b.Thebookvalueoftheexistingmachine.
c.Theoriginalcostoftheexistingmachine.
d.Thedepreciatedcostoftheexistingmachine.

a9.Acompanyisconsideringreplacingamachinewithonethatwillsave
$50,000peryearincashoperatingcostsandhave$20,000more
depreciationexpenseperyearthantheexistingmachine.Thetaxrateis
40%.Buyingthenewmachinewillincreaseannualnetcashflowsofthe
companyby
a.$38,000.
b.$30,000.
c.$20,000.
d.$12,000.

c10.Notforprofitentities
a.cannotusecapitalbudgetingtechniquesbecauseprofitabilityis
irrelevanttothem.
b.cannotusediscountedcashflowtechniquesbecausethetimevalueof
moneyisirrelevanttothem.
c.mighthaveseriousproblemsinquantifyingthebenefitsexpectedfrom
aninvestment.
d.shouldusetheIRRmethodtomakeinvestmentdecisions.

c11.Amajordifferencebetweenaninvestmentinworkingcapitalandonein
depreciableassetsisthat
a.aninvestmentinworkingcapitalisneverreturned,whilemost
depreciableassetshavesomeresidualvalue.
b.aninvestmentinworkingcapitalisreturnedinfullattheendofa
project'slife,whileaninvestmentindepreciableassetshasno
residualvalue.
c.aninvestmentinworkingcapitalisnottaxdeductiblewhenmade,nor
taxablewhenreturned,whileaninvestmentindepreciableassetsdoes
allowtaxdeductions.
d.becauseaninvestmentinworkingcapitalisusuallyreturnedinfull
attheendoftheproject'slife,itisignoredincomputingthe
amountoftheinvestmentrequiredfortheproject.

d12.Thepropertreatmentofaninvestmentinreceivablesandinventoryisto
a.ignoreit.
b.addittotherequiredinvestmentinfixedassets.
c.addittotherequiredinvestmentinfixedassetsandsubtractit
fromtheannualcashflows.
d.addittotheinvestmentinfixedassetsandaddthepresentvalueof
therecoverytothepresentvalueoftheannualcashflows.

104
105
a13.IfacompanyusesafiveyearMACRSperiodtodepreciateassetsinstead
ofa10yearlifewithstraightlinedepreciation,
a.theNPVoftheinvestmentishigher.
b.theIRRoftheinvestmentislower.
c.thereisnodifferenceineitherNPVorIRR.
d.totalcashflowsovertheusefullifewouldbelower.

a14.TheNPVandIRRmethodsgive
a.thesamedecision(acceptorreject)foranysingleinvestment.
b.thesamechoicefromamongmutuallyexclusiveinvestments.
c.differentrankingsofprojectswithunequallives.
d.thesamerankingsofprojectswithdifferentrequiredinvestments.

d15.AninvestmentwithapositiveNPValsohas
a.apositiveprofitabilityindex.
b.aprofitabilityindexofone.
c.aprofitabilityindexlessthanone.
d.aprofitabilityindexgreaterthanone.

b16.ClassifyinganassetinaMACRSlifecategoryisbasedon
a.usefullifeestimatedbythecompany.
b.assetdepreciationrange(ADR)guidelines.
c.thecostoftheasset.
d.anyoftheabovefactors.

d17.Whichofthefollowingmakesinvestmentsmoredesirablethantheyhad
been?
a.Anincreaseintheincometaxrate.
b.Anincreaseininterestrates.
c.Anincreaseinthenumberofyearsoverwhichassetsmustbe
depreciated.
d.Noneoftheabove.

c18.Whichofthefollowingstatementsistrue?
a.Allrevenueistaxed.
b.Allexpensesaretaxdeductible.
c.Somerevenuesandexpenseshavenotaxeffects.
d.Incometaxesarebasedsolelyonrevenuesandexpenses.

b19.Theprofitabilityindexistheratioof
a.totalcashinflowstothecostoftheinvestment.
b.thepresentvalueofcashinflowstothecostoftheinvestment.
c.theNPVoftheinvestmenttothecostoftheinvestment.
d.theIRRtothecompany'scostofcapital.

c20.Withrespecttoincometaxes,theprincipaladvantageofMACRSover
straightlinedepreciationisthat
a.totaltaxeswillbelowerunderMACRS.
b.taxeswillbeconstantfromyeartoyearunderMACRS.
c.taxeswillbelowerintheearlieryearsunderMACRS.
d.taxeswilldeclineinfutureyearsunderMACRS.

a21.Iftheprofitabilityindexislessthanone,
a.theIRRislessthancostofcapital.

106
b.theIRRisthesameascostofcapital.
c.theIRRisgreaterthancostofcapital.
d.noneoftheaboveistrue.

c22.Whichofthefollowingcombinationsispossible?
ProfitabilityIndexNPVIRR

a.greaterthan1positiveequalscostofcapital
b.greaterthan1negativelessthancostofcapital
c.lessthan1negativelessthancostofcapital
d.lessthan1positivelessthancostofcapital

d23.WhichofthefollowingcombinationsisNOTpossible?
ProfitabilityIndexNPVIRR

a.greaterthan1positivemorethancostofcapital
b.equals1zeroequalscostofcapital
c.lessthan1negativelessthancostofcapital
d.lessthan1positivelessthancostofcapital

b24.Incapitalbudgeting,sensitivityanalysisisused
a.todeterminewhetheraninvestmentisprofitable.
b.toseehowadecisionwouldbeaffectedbychangesinvariables.
c.totesttherelationshipoftheIRRandNPV.
d.toevaluatemutuallyexclusiveinvestments.

b25.Auniquefeatureoftheanalysisofareplacementdecisionisthat
a.theanalysisconsiderstotalratherthandifferentialcosts.
b.theamountusedasthecostoftheinvestmentisnotlikelytoequal
thepricetobepaidforthenewasset.
c.thetimevalueofmoneyisignored.
d.suchdecisionsseldominvolvecashflows.

a26.Becauseofidlecapacity,acompanyisconsideringtwoassetsforsale.
TheyareidenticalinallrespectsexceptthatassetAhasahighertax
basisthanassetB.Onlyoneneedbesoldnowandthemarketpriceis
thesameforbothassets.Whichofthefollowingistrue?
a.ThecashflowisgreaterfromsellingassetA.
b.ThecashflowisgreaterfromsellingassetB.
c.Thecashflowisthesamenomatterwhichoneissold.
d.Itisnotpossibletodeterminehowthecashflowsfromsalesofthe
assetswilldiffer.

a27.Ifthetaxlawwerechangedsothatownersofapartmentbuildingshadto
depreciatethemover50yearsinsteadofthecurrent31.5years,
a.rentswouldrise.
b.rentswouldfallbecauseannualdepreciationchargeswouldfall.
c.rentswouldstayaboutthesame.
d.morepeoplewouldinvestinapartmentbuildings.

b28.Whichstatementcouldexpresstheresultsofasensitivityanalysisof
aninvestmentdecision?
a.TheNPVoftheprojectis$50,000.
b.A5%declineinvolumewillmaketheprojectunprofitable.

107
c.Thisprojectranksthirdoutofthefiveavailable.
d.Thisprojectdoesnotmeetthecutoffrateofreturn.

108
c29.XYZCo.isadoptingjustintimeprinciples.Whenevaluatingan
investmentprojectthatwouldreduceinventory,howshouldXYZtreatthe
reduction?
a.Ignoreit.
b.Decreasethecostoftheinvestmentanddecreasecashflowsatthe
endoftheproject'slife.
c.Decreasethecostoftheinvestment.
d.Decreasethecostoftheinvestmentandincreasethecashflowatthe
endoftheproject'slife.

b30.Whichofthefollowingcombinationsofcapitalbudgetingtechniques
includesonlydiscountedcashflowtechniques?
a.Bookrateofreturn,payback,andprofitabilityindex.
b.NPV,IRR,andprofitabilityindex.
c.IRR,payback,andNPV.
d.Profitabilityindex,NPV,andpayback.

d31.Aninvestmentwhoseprofitabilityindexis1.00
a.hasanIRRequaltotheprevailinginterestrate.
b.returnstothecompanyonlythecashoutlayfortheinvestment.
c.hasapaybackperiodequaltoitsusefullife.
d.hasanNPVofzero.

a32.Inconnectionwithacapitalbudgetingproject,aninvestmentinworking
capitalisnormallyrecovered
a.attheendoftheproject'slife.
b.inthefirstyearoftheproject'slife.
c.evenlythroughtheproject'slife.
d.whenthecompanygoesoutofbusiness.

b33.Forinvestmentsthathaveonlycosts(norevenuesorcostsavings),an
appropriatedecisionruleistoaccepttheprojectthathasthe
a.longestpaybackperiod.
b.lowestpresentvalueofcashoutflows.
c.higherpresentvalueoffuturecashoutflows.
d.lowestinternalrateofreturn.

b34.Thecashinflowfromthereturnofaninvestmentinworkingcapitalis
a.adjustedfortaxesdue.
b.discountedtopresentvalue.
c.ignoredifanydepreciableassetsalsoinvolvedintheprojecthave
noexpectedresidualvalue.
d.notreal.

d35.NPVisappropriatetousetoanalyzewhichdecisionrelatingtoajoint
productscompany?
a.Whetherornottosellfacilitiesnowusedforadditionalprocessing
ofoneofthejointproducts.
b.Whetherornottoacquirefacilitiesneededforadditionalprocessing
ofoneofthejointproducts.
c.Whetherornottosellfacilitiesnowusedtooperatethejoint
process.
d.Alloftheabove.

109
d36.IfXCo.expectstogetaoneyearbankloantohelpcovertheinitial
financingofcapitalprojectQ,theanalysisofQshould
a.offsettheloanagainstanyinvestmentininventoryorreceivables
requiredbytheproject.
b.showtheloanasanincreaseintheinvestment.
c.showtheloanasacashoutflowinthesecondyearoftheproject's
life.
d.ignoretheloan.

d37.AprojectthathasanegativeNPV
a.hasapaybackperiodlongerthanitslife.
b.hasanegativeprofitabilityindex.
c.mustberejected.
d.doesn'tnecessarilyfitanyoftheabovedescriptions.

c38.Acompanyevaluatesaprojectusingstraightlinedepreciationoverits
10yearestimatedusefullifeandthenreevaluatesitusinga7year
MACRSclasslife.Thesecondanalysiswillshow
a.alowerIRRfortheproject.
b.thesameNPVandIRRfortheproject.
c.ahigherNPVfortheproject.
d.lowertotalcashflowsoverthe10years.

a39.Assumingthataprojecthasalreadybeenevaluatedusingthefollowing
techniques,theevaluationunderwhichtechniqueisleastlikelytobe
affectedbyanincreaseintheestimatedresidualvalueoftheproject?
a.Paybackperiod.
b.IRR.
c.NPV.
d.PI.

d40.Qualitativefactorscaninfluencemanagersto
a.acceptaninvestmentprojecthavingnegativeNPV.
b.rejectaninvestmentprojecthavinganIRRgreaterthanthecompany's
cutoffrate.
c.raisethe"ranking"ofaninvestmentproject.
d.takeanyoftheabovecoursesofaction.

a41.Thereplacementdecisionis
a.anexampleofadecisionamongmutuallyexclusivealternatives.
b.bestarrivedatbyusingthetotalprojectratherthanthe
differentialapproach.
c.devoidofqualitativeissues.
d.noneoftheabove.

c42.Acmeisconsideringthesaleofamachinewithabookvalueof$160,000
and3yearsremaininginitsusefullife.Straightlinedepreciationof
$50,000annuallyisavailable.Themachinehasacurrentmarketvalueof
$200,000.Whatisthecashflowfromsellingthemachineifthetaxrate
is40%?
a.$50,000
b.$160,000
c.$184,000
d.$200,000

110
111
c43.Hoffisconsideringthesaleofamachinewithabookvalueof$160,000
and3yearsremaininginitsusefullife.Straightlinedepreciationof
$50,000annuallyisavailable.Themachinehasacurrentmarketvalueof
$100,000.Whatisthecashflowfromsellingthemachineifthetaxrate
is40%?
a.$50,000
b.$100,000
c.$124,000
d.$160,000

a44.AltoonaCompanyisconsideringreplacingamachinewithabookvalueof
$200,000,aremainingusefullifeof4years,andannualstraightline
depreciationof$50,000.Theexistingmachinehasacurrentmarketvalue
of$175,000.Thereplacementmachinewouldcost$320,000,havea4year
life,andsave$100,000peryearincashoperatingcosts.Ifthe
replacementmachinewouldbedepreciatedusingthestraightlinemethod
andthetaxrateis40%,whatwouldbetheincreaseinannualincome
taxesifthecompanyreplacesthemachine?
a.$28,000
b.$40,000
c.$42,000
d.$64,000

b45. Aninvestmentopportunitycosting$300,000isexpectedtoyieldnetcash
flowsof$100,000annuallyforfiveyears.Theprofitabilityindexof
theinvestmentatacutoffrateof14%wouldbe
a.3.0.
b.1.14.
c.0.33.
d.14%.

d46.AprojecthasaNPVof$30,000whenthecutoffrateis10%.Theannual
cashflowsare$41,010onaninvestmentof$100,000.Theprofitability
indexforthisprojectis
a.1.367.
b.3.333.
c.2.438.
d.1.300.

c47.AprojecthasanIRRinexcessofthecostofcapital.Theprofitability
indexforthisprojectwouldbe
a.lessthanzero.
b.betweenzeroandone.
c.greaterthanone.
d.cannotbedeterminedwithoutmoreinformation.

b48.AprojecthasanIRRlessthanthecostofcapital.Theprofitability
indexforthisprojectwouldbe
a.lessthanzero.
b.betweenzeroandone.
c.greaterthanone.
d.cannotbedeterminedwithoutmoreinformation.

112
b49.PortagePressCompanyisconsideringreplacingamachinewithabook
valueof$200,000,aremainingusefullifeof5years,andannual
straightlinedepreciationof$40,000.Theexistingmachinehasa
currentmarketvalueof$200,000.Thereplacementmachinewouldcost
$300,000,havea5yearlife,andsave$100,000peryearincash
operatingcosts.Ifthereplacementmachinewouldbedepreciatedusing
thestraightlinemethodandthetaxrateis40%,whatwouldbethe
increaseinannualnetcashflowifthecompanyreplacesthemachine?
a.$60,000
b.$68,000
c.$76,000
d.$84,000

b50.WinneconneCompanyisconsideringreplacingamachinewithabookvalue
of$400,000,aremainingusefullifeof5years,andannualstraight
linedepreciationof$80,000.Theexistingmachinehasacurrentmarket
valueof$400,000.Thereplacementmachinewouldcost$550,000,havea
5yearlife,andsave$75,000peryearincashoperatingcosts.Ifthe
replacementmachinewouldbedepreciatedusingthestraightlinemethod
andthetaxrateis40%,whatwouldbethenetinvestmentrequiredto
replacetheexistingmachine?
a.$90,000
b.$150,000
c.$330,000
d.$550,000

TrueFalse

T1.ThehighertheIRRonaninvestmentproject,thehigherits
profitabilityindex.

F2.Ifthepaybackperiodofaninvestmentprojectisshorterthanitslife,
theproject'sprofitabilityindexisgreaterthan1.

F3.Ifacompanyhasdecidedthatacertaintaskmustbeperformedandthree
machinesaccomplishthattask,themachinewiththelowestinitialcash
outlayshouldbeselected.

T4.AninvestmentwithanIRRgreaterthancostofcapitalhasa
profitabilityindexgreaterthan1.

T5.Theonlycostsandrevenuesrelevanttoareplacementdecisionarethose
thatwillchangeifareplacementismade.

T6.Boththeincrementalandthetotalprojectapproachestoanalyzinga
replacementdecisionshouldyieldthesamedecision.

F7.BoththeIRRandthebookrateofreturnmethodsofanalyzing
investmentsshouldyieldthesamedecision.

F8.Ifthepaybackperiodofaninvestmentisshorterthanitslife,its
profitabilityindexisgreaterthanl.

113
T9.Whencomparedwithstraightlinedepreciation,usingMACRSwillresult
inalargerNPV.

F10.IRRandbookrateofreturnwillusuallyyieldthesamevalueforan
investment.

Problems

1.StockholmCompanyisconsideringthesaleofamachinewiththefollowing
characteristics.

Bookvalue$120,000
Remainingusefullife5years
Annualstraightlinedepreciation$24,000
Currentmarketvalue$70,000

Ifthecompanysellsthemachineitscashoperatingexpenseswillincrease
by$30,000peryearduetoanoperatinglease.Thetaxrateis40%.

a.Findthecashflowfromsellingthemachine.

b.Calculatetheincreaseinannualnetcashoutflowsasaresultof
sellingthemachine.

SOLUTION:

a.Cashflowfromsale:$90,000($70,000+40%taxsavingsonthe$50,000
taxloss)

b.Increaseinannualcashoutflows:$27,600($30,000pretaxcostincrease
$2,400decreaseinincometaxes;the$30,000increaseincashcostsis
partiallyoffsetbylosinga$24,000depreciationdeduction)

2.PepinCompanyisconsideringreplacingamachinethathasthefollowing
characteristics.

Bookvalue$100,000
Remainingusefullife5years
Annualstraightlinedepreciation$???
Currentmarketvalue$60,000

Thereplacementmachinewouldcost$150,000,haveafiveyearlife,and
save$50,000peryearincashoperatingcosts.Itwouldbedepreciated
usingthestraightlinemethod.Thetaxrateis40%.

a.Findthenetinvestmentrequiredtoreplacetheexistingmachine.

b.Computetheincreaseinannualincometaxesifthecompanyreplacesthe
machine.

114
c.Computetheincreaseinannualnetcashflowsifthecompanyreplaces
themachine.

115
SOLUTION:

a.Netinvestment:$74,000[$150,000$60,00040%($100,00060,000)]

b.Increaseinincometaxes:$16,000[40%x($50,000pretaxflow$30,000
depreciation+$20,000lostdepreciation)]

c.Increaseincashflows:$34,000($50,000$16,000increaseinincome
taxes)

3.CableCompanyisconsideringthepurchaseofamachinewiththefollowing
characteristics.

Cost$100,000
Usefullife10years
Expectedannualcashcostsavings$30,000

Cable'sincometaxrateis40%anditscostofcapitalis12%.Cable
expectstousestraightlinedepreciationfortaxpurposes.

a.Computetheexpectedincreaseinannualnetcashflowforthisproject.

b.Computetheprofitabilityindexfortheproject.

c.HowwouldtheprofitabilityindexforthisprojectbeaffectedifCable
weretouseMACRSdepreciationfortaxpurposesandthemachinefell
intothe7yearMACRSclass?(increasedecreasenotaffected)
Circletheappropriateanswer.

SOLUTION:

a.Increaseinannualnetcashflow:$22,000[$30,000(40%x($30,000
$10,000)]

b.Profitabilityindex:1.24[($22,000x5.65)/$100,000]

c.Effectonprofitabilityindex:Increase(PIwouldincreasebecausethe
taxshieldofdepreciationwouldoccurearlierandsobemorevaluablewhen
consideringthetimevalueofmoney.)

4.FrankCo.hastheopportunitytointroduceanewproduct.Frankexpects
theproducttosellfor$60andtohaveperunitvariablecostsof$35and
annualcashfixedcostsof$4,000,000.Expectedannualsalesvolumeis
275,000units.Theequipmentneededtobringoutthenewproductcosts
$6,000,000,hasafouryearlifeandnosalvagevalue,andwouldbe
depreciatedonastraightlinebasis.Frank'scostofcapitalis14%and
itsincometaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

116
c.Supposethatsomeofthe275,000unitsexpectedtobesoldwouldbeto
customerswhocurrentlybuyanotherofFrank'sproducts,theX10,which
hasa$12perunitcontributionmargin.FindthesalesofX10thatcan
Frankloseperyearandstillhavetheinvestmentinthenewproduct
returnatleastthe14%costofcapital.

d.Supposethatsellingthenewproducthasnocomplementaryeffectsbut
thatFrank'sproductionengineersanticipatesomeproductionproblemsin
makingthenewproductandarenotconfidentofthe$35estimateofper
unitvariablecostsforthenewproduct.Findtheamountbywhich
Frank'sestimateofperunitvariablecostcouldbeinerrorandthe
investmentstillhaveareturnatleastequaltothe14%costof
capital.

SOLUTION:

a.Annualnetcashflows:$2,325,000[$2,875,000pretax40%x($2,875,000
$1,500,000depreciation)]

pretaxincome=275,000x($60$35)$4,000,000=$2,875,000

b.NPV:$775,050[($2,325,000x2.914)$6,000,000]

c.AllowablelossofX10sales,approximately36,941units
[($775,050/2.914)/60%]/12

d.AllowableerrorinperunitVC,$1.61

{[($775,050/2.914)/60%]/275,000units}

5.Zenexisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$240,000
Usefullife10years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
operationcosts$80,000
Additionalworkingcapitalneeded$100,000

Zenex'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.Computetheprofitabilityindexoftheproject.

SOLUTION:

a.Annualnetcashflows:$57,600[$80,000pretax40%x($80,000

117
 $24,000depreciation)]

b.NPV:$17,640[($57,600x5.650)$240,000$100,000+($100,000x.322)]

c.PI:1.052{[($57,600x5.650)+($100,000x.322)]/($240,000+$100,000)}

6.DarwinCompanyisconsideringthesaleofamachinewiththefollowing
characteristics.

Bookvalue$110,000
Remainingusefullife5years
Annualstraightlinedepreciation$???
Currentmarketvalue$120,000

Ifthecompanysellsthemachineitscashoperatingexpenseswillincrease
by$20,000peryear.Thetaxrateis40%.

a.Findthecashflowfromsellingthemachine.

b.Calculatetheincreaseinannualnetcashoutflowsasaresultof
sellingthemachine.

SOLUTION:

a.Cashflowfromsale:$116,000($120,00040%taxonthe$10,000tax
gain)

b.Increaseinannualcashoutflows:$20,800($20,000pretaxcostincrease
+$800increaseinincometaxes;the$20,000increaseincashcostsismore
thanoffsetbylosinga$22,000depreciationdeduction)

7.RuskCompanyisconsideringreplacingamachinethathasthefollowing
characteristics.

Bookvalue$200,000
Remainingusefullife4years
Annualstraightlinedepreciation$???
Currentmarketvalue$160,000

Thereplacementmachinewouldcost$300,000,haveafouryearlife,and
save$37,500peryearincashoperatingcosts.Itwouldbedepreciated
usingthestraightlinemethod.Thetaxrateis40%.

a.Findthenetinvestmentrequiredtoreplacetheexistingmachine.

b.Computetheincreaseinannualincometaxesifthecompanyreplacesthe
machine.

c.Computetheincreaseinannualnetcashflowsifthecompanyreplaces
themachine.

118
SOLUTION:

a.Netinvestment:$124,000[$300,000$160,00040%x($200,000
160,000)]

b.Increaseinincometaxes:$5,000[40%x($37,500pretaxflow$75,000
depreciation+$50,000lostdepreciation)]

c.Increaseincashflows:$32,500($37,500$5,000increaseinincome
taxes)

8.ZmolekCompanyisconsideringthepurchaseofamachinecosting$700,000
withausefullifeof10years.Annualcashcostsavingsareexpectedtobe
$200,000.Zmolek'sincometaxrateis40%anditscostofcapitalis12%.
Zmolekexpectstousestraightlinedepreciationfortaxpurposes.

a.Computetheexpectedincreaseinannualnetcashflowforthisproject.

b.Computetheprofitabilityindexfortheproject.

SOLUTION:

a.Increaseinannualnetcashflow:$148,000[$200,00040%x($200,000
$70,000)]

b.Profitabilityindex:1.19[($148,000x5.65)/$700,000]

9.RacineCo.hastheopportunitytointroduceanewproduct.Racineexpects
theprojecttosellfor$200andtohaveperunitvariablecostsof$130
andannualcashfixedcostsof$6,000,000.Expectedannualsalesvolumeis
125,000units.Theequipmentneededtobringoutthenewproductcosts
$7,200,000,hasafouryearlifeandnosalvagevalue,andwouldbe
depreciatedonastraightlinebasis.Workingcapitalof$500,000wouldbe
necessarytosupporttheincreasedsales.Racine'scostofcapitalis12%
anditsincometaxrateis40%.

a.ComputetheNPVofthisopportunity.

b.Computetheprofitabilityindexofthisopportunity.

SOLUTION:

a.NPV:negative$184,310

Annualcashflow:$2,370,000=60%x[125,000x($200$130)]
60%x$6,000,000+40%x$7,200,000/4

NPV:[($2,370,000x3.037)$7,200,000500,000+($500,000x.636)]

119
b.PI:0.976[($2,370,000x3.037+500,000x.636)/($7,200,000+500,000)]

10.Seilerisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$2,000,000
Usefullife8years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
operationcosts$750,000
Additionalworkingcapitalneeded$500,000

Seiler'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.Computetheprofitabilityindexoftheproject.

SOLUTION:

a.Annualnetcashflows:$550,000[$750,00040%x($750,000$250,000
depreciation)]

b.NPV:$434,400[($550,000x4.968)$2,000,000$500,000+($500,000
x.404)]

c.PI:1.17{[($550,000x4.968)+($500,000x.404)]/($2,000,000+$500,000)}

120