Questions Chapter 10

Questions Chapter 10
1) Side effects such as erosion should be considered in a capital budgeting decision.
[A] True
[B] False
[A] :You are correct!

[B] :A project’s cash flows should include all changes in a firm’s future cash flows. This includes side effects. Review
section 10.2.
2) The _____ approach for computing project operating cash flow explicitly measures the depreciation-related tax
benefit associated with an investment.
[A] stand-alone
[B] bottom-up
[C] top-down
[D] tax shield
[E] traditional
[A] :This is not a method of computing operating cash flow. Review section 10.5.
[B] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project.
Review section 10.5.
[C] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project.
[D] :You are correct!
[E] :This method of computing operating cash flow does not isolate the depreciation-related tax benefits of a project.
3) To accurately reflect the costs associated with a project, you should exclude interest expenses in the computation
of the operating cash flows.
[A] True
[B] False

[B] :Interest expenses result from financing, not operating choices. Review section 10.2.
4) A sunk cost is an incremental cash flow.
[A] True
[B] False
[A] :Sunk costs are costs that have been incurred and cannot be removed. Therefore, they are not incremental cash
flows. Review section 10.2.
[B] :You are correct!
5) An opportunity cost is the most valuable alternative that is given up if a particular investment is undertaken.
[A] True
[B] False

[B] :This is the definition of an opportunity cost. Review section 10.2.
6) The managers of Poncho Parts, Inc. plan to manufacture engine blocks for classic cars from the 1960s. They
expect to sell 250 blocks annually for the next 5 years. The necessary foundry and machining equipment will cost a
total of $800,000 and will be depreciated on a straight-line basis to zero over the project's life. The firm expects to be
able to sell the equipment for $150,000 at the end of 5 years. Labor and materials costs total $500 per engine block,
fixed costs are $125,000 per year. Assume a 35 percent tax rate and a 12 percent discount rate. What is the
expected after-tax cash flow to the firm when the equipment is sold in year five?
[A] $65,000
[B] $97,500
[C] $100,000
[D] $115,000
[E] $120,125
[A] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to
$52,500. Review section 10.3.
[C] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to
[D] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to
[E] :In this case the cash selling price is $150,000, the taxable gain is $150,000, and taxes on the sale amount to
7) Given the following information and assuming straight-line depreciation to zero, what is the internal rate of return of
this project? Initial investment = $400,000; life = 4 years; cost savings = $125,000 per year; tax rate = 34 percent;
discount rate = 12 percent. The fixed assets will be sold for $20,000 at the end of year 4.
[A] 6.25 percent

[B] 7.51 percent
[C] 8.15 percent
[D] 9.43 percent
[E] 10.24 percent
[A] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets
to be $13,200? Review section 10.3.
[C] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets
[D] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets
[E] :Did you find the OCF each year to be $116,500 and the terminal after-tax cash flow from the sale of fixed assets
8) Incremental cash flows are the difference between a firm's future cash flows if a project is accepted and the future
cash flows if the project is rejected.
[A] True
[B] False

[B] :This is the definition of an incremental cash flow. Review section 10.1.
9) You are considering investing in a cost cutting proposal. Net income from the project is expected to equal $27.50
each of the three years of the project's life. The process has an initial cost of $125 and will be depreciated straight-
line over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent. What
is the value of the tax shield in each period from the investment in the process?
[A] $6.80
[B] $8.50
[C] $14.17
[D] $27.50
[E] $41.67
[A] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[B] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[C] :You are correct!
[D] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[E] :Did you find the annual depreciation to be $41.67? Review section 10.5.
10) Which of the following statements are correct?

I. Setting the bid price requires finding the point at which NPV is zero.
II. In a cost-cutting proposal the reduction in costs has the same effect as an increase in sales.
III. Equivalent annual cost is used to evaluate mutually exclusive projects with different lives if the projects are
expected to be replicated forever.
[A] III only

[B] I and II only
[C] I and III only
[D] II and III only
[E] I, II, and III
[A] :Correct, but there is at least one other correct option. Review section 10.6.
[B] :Correct, but the third response is correct as well since it states important assumptions relating to EAC. Review
section 10.6.
[C] :Correct, but the second response is correct as well. Review section 10.6.
[D] :Correct, but the first response is correct as well since it correctly describes the process of setting a bid price.
[E] :You are correct!
11) Which one of the following describes the "tax shield" approach to computing operating cash flow?
[A] EBIT + D - Taxes

[B] NI + D
[C] (S - C) X (1 - Tc) + D X Tc
[D] S - C - Taxes
[E] EBIT + D X - Tc
[A] :This is the most general method of computing operating cash flow. Review section 10.5.
[B] :This is the bottom up approach. Review section 10.5.
[D] :This is the top down approach. Review section 10.5.
[E] :This is not one of the ways of computing operating cash flow. Review section 10.5.
12) Consider the following balance sheet entries:

Entry : Beginning : Ending
Accounts receivable (AR) : $250 : $270
Inventory (I) : $225 : $218
Accounts payable (AP) : $250 : $241
Which of the accounts represent(s) a cash outflow?
[A] AR only
[B] AP only
[C] I only
[D] AR and AP only
[E] I and AP only
[A] :This is a cash outflow but it is not the only one. Review section 10.4.
[B] :This is a cash outflow but it is not the only one. Review section 10.4.
[C] :If an asset account decreases it is a cash inflow. Review section 10.4.
[E] :If an asset account decreases it is a cash inflow. Review section 10.4.
13) Your company just purchased a new computer system for $130,000. Computers have a 5-year MACRS
classification. What is the depreciation for this system in year 2?
[A] $28,899
[B] $31,837
[C] $41,600
[D] $43,329
[E] $57,772
[A] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section 10.4.
[B] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section 10.4.
[D] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section 10.4.
[E] :The MACRS percentage for year 2 is 32 percent for five-year property. Review section 10.4.
14) Total project cash flow is the same as cash flow from assets. That is, it is equal to operating cash flow minus
changes in net working capital minus net capital spending.
[A] True
[B] False

[B] :This is the definition of total project cash flow from chapter 10 and cash flow from assets from chapter 2. Review
section 10.3.
15) A project costs $20,000, will be depreciated straight-line to zero over its 3-year life, will require a net working
capital investment of $5,000 up front, has a tax rate of 34 percent and a required return of 10 percent. The fixed
assets will be sold for $2,000 at the end of year three. The project generates an operating cash flow of $13,000.
What is the project's net present value?
[A] $10,724
[B] $11,033
[C] $12,077
[D] $13,426
[E] $15,942
[A] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of
NWC, and $1,320 from the sale of the fixed assets? Review section 10.3.
[B] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of
[D] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of
[E] :Did you find that in addition to the OCF in year 3, the project will generate cash inflows of $5,000 for recovery of
16) Given the following information and assuming straight-line depreciation to zero, what is the payback period for
discount rate = 13 percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your answer to the
nearest 1/10th of a year)
[A] 2.5 years

[B] 3.6 years
[C] 3.9 years
[D] 4.4 years
[E] The payback period is greater than the project's life
[A] :Did you find the OCF to be $139,600? Review section 10.3.
[C] :Did you find the OCF to be $139,600? Review section 10.3.
[D] :Did you find the OCF to be $139,600? Review section 10.3.
[E] :The project does pay back prior to the end of its life. Did you find the OCF to be $139,600? Review section 10.3.
17) Your company purchased a piece of land five years ago for $150,000 and subsequently added $175,000 in
improvements. The current book value of the property is $225,000. There are two options for future use of the land:
1) the land can be sold today for $375,000 after-tax; or 2) your company can destroy the past improvements and
build a factory on the land. When evaluating the factory option, what amount, if any, should be included for the use of
the land?
[A] $0
[B] $200,000
[C] $225,000
[D] $325,000
[E] $375,000
[A] :What about the opportunity cost? Review section 10.2.

[B] :What is a sunk cost? Review section 10.2.
[C] :Is opportunity cost based on book value or market value? Review section 10.2.
[D] :Are sunk costs relevant for this project? Review section 10.2.
18) Your company just bought a new distillation unit for $130,000 to be used in R&&D. Such equipment has a 3-year
MACRS classification. What is the book value of the distillation unit at the end of year 2?
[A] $28,899
[B] $35,568
[C] $39,899
[D] $57,775
[E] $58,896
[B] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to
arrive at the book value at the end of year two. Review section 10.4.
[C] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to
[D] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to
[E] :The depreciation in year one is $43,329 and the depreciation in year two is $57,772. Use these numbers to
19) When we employ _______, 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 law of one price
[D] Bell's theorem
[E] the equivalent annual cost procedure

[B] :We have discussed no such theorem. Review section 10.1.
[C] :We have discussed no such law. Review section 10.1.
[D] :We have discussed no such theorem. Review section 10.1.
[E] :The EAC does rely on evaluating incremental cash flows, but it is not the term that describes this process in
general. Review section 10.6.
20) What is the difference between a project’s operating cash flow (OCF) and the project’s cash flow (PCF)?
[A] PCF = OCF plus the change in project change in net working capital minus plus project capital spending
[B] OCF = PCF minus the project change in net working capital plus depreciation
[C] OCF = PCF plus the project change in net working capital
[D] PCF = OCF minus the project change in net working capital minus the project capital spending
[E] PCF = OCF plus the depreciation tax shield.
[A] :Are you plus and minus signs correct? Review section 10.3.
[B] :Please try again. Review section 10.3.
[C] :You are missing one variable in the equation. Review section 10.3.
[E] :Please try again. Review section 10.3.
21) When considering mutually exclusive investment projects with different lives that will not be replaced after they
terminate, it is best to evaluate them using the _____ method.
[A] discounted payback

[B] profitability index
[C] equivalent annual cost
[D] internal rate of return
[E] net present value
[A] :Although this is one way to evaluate the projects, this is not the best choice. Review section 9.3.
[B] :This method should not be used for mutually exclusive investments. Review section 9.6.
[C] :This would be correct if they were going to be replaced, but they aren't. Review section 10.6.
[D] :This method should not be used for mutually exclusive investments. Review section 9.5.
22) You are given the following information about equipment that is required for your business. Assume that the
equipment will be replaced as it wears out and that straight-line depreciation to zero is used. The required return is 15
percent. Ignore taxes. Machine A has an initial cost of $200,000, an operating cost per year of $15,000, and an
expected life of 8 years. Machine B has an initial cost of $300,000, an operating cost per year of $17,500, and an
expected life of 10 years. What is the equivalent annual cost of machine A?
[A] -$301,664
[B] -$201,676
[C] -$48,163
[D] -$59,570
[E] -$22,437
[A] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section 10.6.
[B] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section 10.6.
[C] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section 10.6.
[E] :To find the EAC, you must first find the NPV of machine A. Did you get -$267,310 for this? Review section 10.6.
equipment will be replaced as it wears out and that straight-line depreciation to zero is used. The required return is 15
percent. Ignore taxes. Machine A has an initial cost of $200,000, an operating cost per year of $15,000, and an
expected life of 8 years. Machine B has an initial cost of $300,000, an operating cost per year of $17,500, and an
expected life of 10 years. What is the equivalent annual cost of machine B?
[A] -$61,664
[B] -$77,276
[C] -$85,776
[D] -$90,163
[E] -$94,113
[A] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section 10.6.
[C] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section 10.6.
[D] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section 10.6.
[E] :To find the EAC, you must first find the NPV of machine B. Did you get -$387,828 for this? Review section 10.6.
24) Your firm needs a computerized line-boring machine that costs $80,000, and requires $20,000 in maintenance for
each year of its 3-year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year
class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. Assume the machine can be
sold for $10,000 at the end of year three. What is the after-tax salvage value at the end of year 3?
[A] $4,544
[B] $5,616
[C] $6,600
[D] $8,616
[E] $9,678
[A] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to
$1,384.48. Review section 10.4.
[B] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to
[C] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to
[E] :The book value at the end of year 3 is $5,928, so the taxable gain is $4,072 and taxes on the gain amount to
25) Which one of the following statements regarding operating cash flows (OCF) is correct?
[A] In order to compute OCF, you need both a balance sheet and an income statement.
[B] Changes in OCF will occur when cost of goods sold changes, all else equal.
[C] Changes in OCF result directly from changes in financing.
[D] OCF for a project can be found by subtracting depreciation from project net income.
[E] An increase in depreciation will cause a decrease in OCF.
[A] :Which element of OCF is found on the balance sheet? Review section 10.3.
[C] :Financing expenses are not included in OCF. Review section 10.3.
[D] :Depreciation can be added to net income to compute OCF as long as the interest expense is equal to zero.
[E] :If you review the tax-shield approach to computing OCF, you will see that this cannot be the case. Review
section 10.3.
26) You are bidding to supply 3 jets per year for each of the next three years to the Navy. To get set up, you will need
$10 million in equipment which will be depreciated straight-line to zero over three years and have no salvage value.
Total fixed costs per year are $5 million and variable costs are $7 million per jet. The tax rate is 30 percent and the
required return is 10 percent. A reasonable bid, which leaves room for a small margin of error, would be a price per
jet of _____ million.
[A] $5
[B] $6
[C] $9
[D] $11
[E] $32
[A] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is
$3,333,333 per year. Now work backwards up the income statement to find sales. Review section 10.6.
[B] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is
[C] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is
[E] :The OCF that makes the NPV zero is $4,021,148. This results in a net income of $687,815 since depreciation is
27) Given the following information and assuming straight-line depreciation to zero, what is the NPV for this project?
Initial investment in fixed assets = $800,000; net working capital requirement = $200,000; life = 4 years; cost savings
= $400,000 per year; tax rate = 35 percent; discount rate = 12 percent. The fixed assets will be sold for $100,000 at
the end of year 4. (Round to the nearest whole dollar)
[A] $95,101
[B] $105,967
[C] $133,560
[D] $170,738
[E] $204,289
[A] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
plus $65,000 for the after-tax sale of the fixed assets? Review section 10.4.
[B] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
[C] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
[E] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
line over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent. What
is operating cash flow in each of the three periods?
[A] $36.30
[B] $43.10
[C] $44.80
[D] $61.80
[E] $69.17
[A] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[B] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[C] :Did you find the annual depreciation to be $41.67? Review section 10.5.
[D] :Did you find the annual depreciation to be $41.67? Review section 10.5.
29) A firm experiences ________ when the cash flows of a new project come at the expense of a firm's existing
projects.
[A] the stand-alone principle

[B] sunk costs
[C] erosion
[D] capital analysis
[E] a negative net present value
[A] :This is not the term that fits this definition. Review section 10.2.
[B] :This is not the term that fits this definition. Review section 10.2.
[D] :This is not the term that fits this definition. Review section 10.2.
[E] :This is not the term that fits this definition. Review section 10.2.
30) Your company just bought some new equipment for its manufacturing plant. The equipment cost $130,000.
Industrial equipment has a MACRS classification of 7 years. If the equipment will be sold at the end of year 3 for
$85,000, what is the after-tax cash flow from the sale? The corporate tax rate is 34 percent.
[A] $27,784
[B] $66,000
[C] $72,216
[D] $75,429
[E] $97,116
[A] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review
section 10.4.
[B] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review
section 10.4.
[C] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review
section 10.4.
[E] :Did you find the ending book value to be $56,849 and the resulting taxable gain on sale to be $28,151? Review
section 10.4.
31) Which one of the following is correct concerning project evaluation?
[A] Financing costs must be included in the cash flows of a proposed project because they are not accounted for
elsewhere.
[B] The stand-alone principle calls for evaluation of a project based on the project's incremental cash flows.
[C] Changes in net working capital are excluded from the incremental cash flows of a project.
[D] When fixed assets are sold at the end of a project, there are usually no tax consequences of the sale.
[E] The decision to use straight-line depreciation or MACRS depreciation is used will have no impact on the net
present value of a project.
[A] :Financing costs are not incremental cash flows of a project. Review section 10.2.
[C] :Changes in net working capital are considered to be incremental cash flows in capital investment analysis.
[D] :There will be tax consequences if the sale price and book values differ. Review section 10.4.
[E] :Using MACRS depreciation will increase the NPV because it increases project cash flows in the early years of a
project. Review section 10.4.
32) Which one of the following is NOT a definition of operating cash flow?

[B] NI + D
[C] (S - C) X (1 - Tc) + D X Tc
[D] S - C - Taxes
[E] S - C - EBIT X (1 - Tc)
[A] :This is the most general method of computing OCF. Review section 10.5.
[B] :This is the bottom-up approach. Review section 10.5.
[C] :This is the tax shield approach. Review section 10.5.
33) Which one of the following is NOT considered to be an incremental cash flow in capital budgeting analysis?
[A] opportunity cost

[B] erosion
[C] additions to NWC
[D] sunk cost
[E] fixed asset salvage values at the end of the project
[A] :This is considered to be an incremental cash flow in capital investment analysis. Review section 10.2.
[B] :This is considered to be an incremental cash flow in capital investment analysis. Review section 10.2.
[C] :This is considered to be an incremental cash flow in capital investment analysis. Review section 10.2.
[E] :This is considered to be an incremental cash flow in capital investment analysis. Review section 10.2.
class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is the depreciation tax
shield for year 3?
[A] $2,016
[B] $3,513
[C] $4,031
[D] $5,222
[E] $5,719
[A] :The appropriate MACRS percentage for year 3 is 14.82 percent, so the depreciation is $11,856 for that year.
[B] :The appropriate MACRS percentage for year 3 is 14.82 percent, so the depreciation is $11,856 for that year.
[D] :The appropriate MACRS percentage for year 3 is 14.82 percent, so the depreciation is $11,856 for that year.
[E] :The appropriate MACRS percentage for year 3 is 14.82 percent, so the depreciation is $11,856 for that year.
35) It is important to identify and use only incremental cash flows in capital investment decisions:
[A] because they are the simplest to identify.

[B] only when the stand alone principle fails to hold.
[C] because ultimately it is the change in a firm's overall future cash flows that matter.
[D] in order to accommodate unforeseen changes that might occur.
[E] whenever sunk costs are involved.
[A] :Actually, they can be quite difficult to identify. Review section 10.3.
[B] :You should use incremental cash flows when the stand-alone principle holds. Review section 10.1.
[D] :You cannot accommodate changes you can't foresee. Review section 10.3.
[E] :Sunk costs should never be a part of the analysis. Review section 10.2.
36) Given the following information and assuming straight-line depreciation to zero, what is the discounted payback
period for this project? Initial investment = $500,000; life = 5 years; cost savings = $160,000 per year; salvage =
$30,000 in year 5; tax rate = 34 percent; discount rate = 13 percent.
[A] more than 3.0 but less than 3.5 years

[B] more than 3.5 but less than 4.0 years
[C] more than 4.0 but less than 4.5 years
[D] more than 4.5 but less than 5.0 years
[E] The discounted payback period is greater than the project's life
[A] :Did you find the OCF to be $139,600? Review section 10.3.
[B] :Did you find the OCF to be $139,600? Review section 10.3.
[E] :If you include the $19,800 after-tax cash flow from the sale of fixed assets at the end of the project, the project
does pay back on a discounted basis.
37) You are advising a friend who is attempting to decide whether or not to drop one of the courses they are currently
enrolled in. If they do, they will forfeit half of the money spent on tuition. Which of the following conclusions drawn by
your friend is consistent with capital budgeting principles?
I. Remaining in the class incurs opportunity cost because they have to reduce the number of hours they are gainfully
employed.
II. The tuition is irrelevant to the decision because it is a sunk cost.
III. The time and energy put into the course thus far is a sunk cost.
[A] I only
[B] I and II only
[C] I and III only
[D] II and III only
[E] I, II, and III
[A] :Correct, but there is at least one more correct option. Review section 10.2.
[B] :At least one of these choices is incorrect. Review section 10.2.
[D] :At least one of these choices is incorrect. Review section 10.2.
[E] :At least one of these choices is incorrect. Review section 10.2.
38) The incremental cash flows related to a capital investment project are easiest to identify when:
[A] sunk costs exist.

[B] opportunity costs are significant.
[C] a proposed project has no effect on the current operations.
[D] erosion of cash flow is expected to occur.
[E] the project has no impact on total fixed assets.
[A] :Sunk costs should never be a part of the analysis. Review section 10.2.
[B] :Opportunity costs can be difficult to identify and value. There is a better response. Review section 10.2.
[D] :Erosion can be difficult to identify and value. There is a better response. Review section 10.2.
[E] :Even a project that requires no investment in fixed assets can be difficult to evaluate if erosion and opportunity
costs exist. There is a better choice. Review section 10.2.
39) Pro forma statements:
[A] are generally created by first estimating production costs.

[B] for a proposed project generally consider only the first year of the project.
[C] recap a firm’s activities for the past year.
[D] should only be prepared when considering a capital budgeting project.
[E] should use realistic assumptions.
[A] :The first step generally is to estimate sales. Go back and review section 4.2.
[B] :Pro forma statements are generally prepared for the life of a project, which is normally more than one year.
[C] :Pro forma statements look at the future, not the past. Review section 10.3.
[D] :You should always be looking ahead. Thus, pro forma statements should be prepared on a routine basis.
40) Consider a $10,000 machine that will reduce pre-tax operating costs by $3,000 per year over a 5-year period.
Assume no changes in net working capital and a scrap value of zero after five years. For simplicity, assume straight-
line depreciation to zero, a marginal tax rate of 34 percent, and a required return of 10 percent. The net present
value, rounded to the nearest whole dollar, is:
[A] $83.
[B] $449.
[C] $689.
[D] $827.
[E] $1,235.

[B] :Did you find the OCF to be $2,660? Review section 10.3.
[D] :Did you find the OCF to be $2,660? Review section 10.3.
[E] :Did you find the OCF to be $2,660? Review section 10.3.
41) In setting the bid price, we attempt to set a price at which the firm will "break even" in a financial sense. Which
one of the following equations does NOT hold at the lowest acceptable bid price?
[A] AAR = required return

[B] NPV = 0
[C] discounted payback = the life of the project
[D] IRR = required return
[E] PI = 1

[B] :When the NPV is zero, the firm expects to earn at least its required rate of return. Review section 10.6.
[C] :When the discounted payback is equal to the project's life, the NPV will be zero. Review section 10.6.
[D] :When the IRR is equal to the required return, the NPV will be zero. Review section 10.6.
[E] :When the PI is equal to one, the NPV will be zero. Review section 10.6.
42) Your firm is selling a machine it purchased two years ago. The selling price is approximately 50 percent less than
the book value of the machine. As a result of this transaction, your firm has a tax benefit in the amount of the tax rate
multiplied by the difference between the:
[A] selling price and the original purchase price.

[B] original purchase price and the book value.
[C] selling price and the current market value.
[D] selling price and the book value.
[E] original purchase price and the current market value.
[A] :Since the machine must have been partially depreciated over the past two years, the original purchase price is
no longer relevant. Review section 10.4.
[B] :Since the machine must have been partially depreciated over the past two years, the original purchase price is
[C] :The selling price and current market value are the same thing. Review section 10.4.
[E] :Since the machine must have been partially depreciated over the past two years, the original purchase price is

Inventory (I) : $225 : $218
Which of the accounts represent(s) a cash inflow?
[A] AR only
[B] AP only
[C] I only
[D] AR and AP only
[E] I and AP only
[A] :If an asset account increases it is a use of cash. Review section 10.4.
[B] :If a liability account decreases it is a use of cash. Review section 10.4.
[D] :If an asset account increases or a liability account decreases it is a use of cash. Review section 10.4.
[E] :If a liability account decreases it is a use of cash. Review section 10.4.
44) Which of the following is (are) explicitly considered in the calculation of MACRS depreciation?
I. actual expected economic life of the asset
II. asset cost
III. asset property class
IV. expected salvage value
[A] IV only
[B] II and III only
[C] I and IV only
[D] III only
[E] I, II, III, and IV
[A] :There is no consideration of salvage value with MACRS depreciation. Review section 10.4.
[C] :At least one of these choices is incorrect. Review section 10.4.
[D] :Correct, but there is at least one more correct option. Review section 10.4.
[E] :At least one of these choices are incorrect. Review section 10.4.
45) The depreciation tax shield is the tax savings which results from the depreciation deduction.
[A] True
[B] False

[B] :This is the definition of the depreciation tax shield. Review section 10.5.
46) The government has been trying to decide whether or not to purchase any of the new, advanced missiles it has
developed. One of the arguments in favor of purchasing the missiles is that so much money has been spent on their
development that it would be a waste of money not to buy any. What is the major problem with this argument?
[A] It ignores the opportunity cost of the money that has been spent.
[B] It includes sunk costs in the decision.
[C] It includes opportunity costs in the decision.
[D] It includes changes in net working capital.
[E] It includes financing costs in the decision.
[A] :Money that has already been spent is not an opportunity cost. Review section 10.2.
[C] :Money that has already been spent is not an opportunity cost. Review section 10.2.
[D] :Changes in net working capital are not the issue here. Review section 10.2.
[E] :Financing costs are not the issue here. Review section 10.2.
47) Which one of the following statements regarding cash flow is correct?
[A] Cash flow and net income are the same when the interest expense is ignored.
[B] Interest expense is part of the operating cash flow of a project.
[C] In evaluating capital budgeting decisions, cash flows should be valued on a pre-tax basis.
[D] After-tax cash flow is usually identical to accounting profits.
[E] Incremental cash flows should include opportunity costs but not sunk costs.
[A] :What about depreciation? Review section 10.5.

[B] :Is interest related to capital budgeting or capital structure? Review section 10.2.
[C] :Are taxes a cash or a noncash expense? Review section 10.5.
[D] :What about depreciation or other non-cash expenses? Review section 10.5.
48) Given the following information and assuming straight-line depreciation to zero, what is the net present value of
discount rate = 14 percent. The fixed assets will be sold for $30,000 at the end of year 5. (Round your answer to the
nearest whole dollar.)
[A] -$149,841
[B] -$33,117
[C] $0
[D] $19,800
[E] $43,538
[A] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5?
Review sections 10.3 and 10.4.
[B] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5?
[C] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5?
[D] :Did you find an OCF of $126,200 for each year and an after-tax cash flow from salvage of $19,800 in year 5?
49) A firm is considering a project that would increase accounts receivable by $10,000, accounts payable by
$35,000, and inventory by $30,000. Which one of the following is true if the project is accepted?
[A] sales will increase

[B] current assets will decrease
[C] net working capital will decrease
[D] project net working capital will be a source of cash
[E] current liabilities will increase
[A] :You cannot make this assumption based on the information given. Review section 10.4.
[B] :You cannot make this assumption based on the information given. Review section 10.4.
[C] :Current assets have increased faster than current liabilities. Has NWC decreased if this is true? Review section
10.4.
[D] :Assets increased faster than liabilities so uses of cash have outpaced sources. Review section 10.4.
50) In general, adopting MACRS depreciation instead of straight-line depreciation will increase the net present value
of a project.
[A] True
[B] False

[B] :By adopting MACRS depreciation, the tax benefits of depreciation are shifted closer to the present, raising the
present value of the project cash flows. Review section 10.4.
51) Assume that over the life of a project, net working capital is maintained at an amount equal to the initial
investment. If so, net working capital can be excluded from the net present value computation, since the outflow at
time zero is exactly offset by an equal inflow at the end of the project's life.
[A] True
[B] False
[A] :The inflow at the end of the project must be discounted to the present, making it less valuable than the amount
initially invested. Review section 10.4.
52) The equivalent annual cost method of evaluating projects applies to projects that have ________ economic lives
and assets which will ________
[A] equal; never be replaced.

[B] equal; be replaced more or less indefinitely.
[C] different; never be replaced.
[D] different; be replaced more or less indefinitely.
[E] either equal or different; never be replaced.
[A] :You are totally wrong. Please try again. Review section 10.6.
[B] :You are only half right. Review section 10.6.
[C] :You are only half right. Review section 10.6.
[E] :You are totally wrong. Please try again. Review section 10.6.

Inventory (I) : $225 : $218
What is the net cash flow from net working capital?
[A] -28
[B] -22
[C] -4
[D] 4
[E] 18
[A] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net
change in I and sum these to find the total net cash flow. Review section 10.4.
[C] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net
[D] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net
[E] :The changes in AP result in a cash outflow of $9; the changes in AR result in a cash outflow of $20. Find the net
54) Which of the following describe relevant cash flows for the purpose of performing capital budgeting analysis?
I. incremental cash flow
II. tax shield
III. changes in net working capital
IV. changes in fixed assets
[A] I and III only

[B] I, II, and III only
[C] I and IV only
[D] II, III, and IV only
[E] I, II, III, and IV
[B] :Why aren't additions to fixed assets relevant? Review section 10.2.
[C] :Correct, but there is at least one more correct option. Review section 10.2.
[D] :Why aren’t incremental cash flows relevant? Review section 10.2.
55) When you set the net present value equal to zero in calculating your bid price you are:
[A] going to earn a net income of zero on the project.

[B] appropriately including opportunity costs in your analysis.
[C] certain to be the lowest bidder since any lower price will result in a negative NPV.
[D] assured of earning your firm's highest possible internal rate of return.
[E] finding the price at which you expect to create zero wealth for your stockholders.
[A] :Is net income always zero when the net present value is zero? Review section 10.6.
[B] :You should include opportunity costs if they exist but they are not discussed here. Review section 10.6.
[C] :Firms have different cost structures and operating characteristics, making it possible for another firm to have a
lower financial break-even point than you have. Review section 10.6.
[D] :When you set the NPV equal to zero, you are expecting to earn a return equal to your required return. Review
section 10.6.
56) Taxes are not an important consideration in evaluating capital investment proposals.
[A] True
[B] False
[A] :Since taxes must be paid in cash, they are an important cash outflow that must be considered in capital
budgeting decisions. Review section 10.2.
57) Given the following information and assuming straight-line depreciation to zero, what is the profitability index for
discount rate = 13 percent. The fixed assets will be sold for $10,000 at the end of year 5.
[A] 0.45
[B] 0.74
[C] 0.99
[D] 1.65
[E] 1.98
[A] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be
$6,600 at the end of year five? Review section 10.3.
[B] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be
[D] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be
[E] :Did you find the OCF to be $139,600 for each year and the after-tax cash flow from the sale of fixed assets to be
58) The information you have on a proposed project includes the sales, net income, depreciation, and the initial
investment. The easiest method for you to use to compute the operating cash flow is the _____ method.
[A] conventional
[B] tax shield
[C] bottom-up
[D] top-down
[E] depreciation first
[A] :To use this approach, you would need to be able to compute earnings before interest and taxes which you
cannot do given the information you have available. Review section 10.5.
[B] :To use this approach, you would need to know the tax rate. Review section 10.5.
[D] :To use this approach, you would need to know the amount of the taxes. Review section 10.5.
[E] :There is no such approach to computing operating cash flow. Review section 10.5.
59) Which one of the following describes the "bottom-up" approach to computing operating cash flow?

[B] NI + D
[C] (S - C) X (1 - Tc) + D X Tc
[D] S - C -Taxes
[E] NI + D - taxes
[E] :This is not one of the ways of computing operating cash flow. Review section 10.5.
60) Sunk cost is another term which describes opportunity cost.
[A] True
[B] False
[A] :A sunk cost is a cost that has been incurred and cannot be recovered. How does this differ from an opportunity
cost? Review section 10.2.
61) An increase in ________ will usually represent a net cash inflow at the beginning or during the life of a project
and an equal net cash outflow upon completion of the project.
[A] accounts payable

[B] inventory
[C] accounts receivable
[D] fixed assets
[E] accounts receivable coupled with an identical increase in accounts payable

[B] :This would be a cash outflow at the outset and an inflow at the end. Review section 10.4.
[C] :This would be a cash outflow at the outset and an inflow at the end. Review section 10.4.
[D] :This would be a cash outflow at the outset, but not necessarily an inflow at the end. Review section 10.4.
[E] :This would be a net cash flow of zero. Review section 10.4.
62) By using the tax shield approach for computing operating cash flows, you can:
[A] obtain more accurate results than with the customary methods.
[B] more readily verify what cash flows would be without interest expenses.
[C] more readily identify the tax shield from interest deductions.
[D] more readily identify the tax benefits of depreciation.
[E] start with the bottom line, net income, and work backwards.
[A] :The methods of computing operating cash flows are equally accurate. Review section 10.5.
[B] :The tax shield approach does not deal with interest expense. Review section 10.5.
[C] :The tax shield approach deals with depreciation, not interest expense. Review section 10.5.
[E] :This response describes the bottom-up approach, not the tax shield approach. Review section 10.5.
63) When we use the equivalent annual cost methodology, the projects under consideration have different economic
lives and the related assets will be replicated more or less indefinitely.
[A] True
[B] False

[B] :This is the definition of when the EAC method of evaluating projects is appropriate. Review section 10.6.
64) Which one of the following projects would increase net working capital the most?
[A] purchasing land for a new baseball manufacturing plant

[B] decreasing the amount of sales your firm makes on credit
[C] decreasing the number of product lines your firm carries
[D] converting a manufacturing process so that you produce goods only after a customer order has been received
[E] using long-term bank credit to reduce payables
[A] :This would increase fixed assets, not current assets. Review section 10.4.
[B] :This would decrease accounts receivable, thereby reducing net working capital. Review section 10.4.
[C] :This would decrease inventory, thereby reducing net working capital. Review section 10.4.
[D] :This would decrease inventory, thereby reducing net working capital. Review section 10.4.
65) Which one of the following is true about net working capital?
[A] Projects in which a firm expands its operations and sales will generally not lead to changes in net working capital.
[B] Changes in net working capital account for differences between accounting sales and costs and actual cash
receipts and payments.
[C] Net working capital is typically an expense at the beginning of a project and an equal inflow at the end, thus
having no impact on NPV.
[D] Dollar changes in the cash account and changes in net working capital are generally equal.
[E] Net working capital is not considered an investment for the firm.
[A] :The situation described here will generally lead to increases in net working capital. Review section 10.4.
[C] :You are forgetting to consider the time value of money when addressing the cash inflow at the end of the
project. Review section 10.4.
[D] :Changes in the cash account are just one part of the changes in net working capital. Review section 10.4.
[E] :Net working capital is considered an investment. Review section 10.4.
66) In a cost cutting proposal, the net present value will generally be negative but the project will still be considered
acceptable.
[A] True
[B] False
[A] :Cost cutting proposals are handled just as any other capital budgeting project would be, meaning that a negative
NPV should result in the project being rejected. Review section 10.6.
67) Which of the following methods for computing project operating cash flow could you use if the only income
statement items you know are project net income and project depreciation?
I. bottom-up approach
II. top-down approach
III. tax shield approach
[A] I only
[B] II only
[C] III only
[D] I and II only
[E] I and III only

[B] :You cannot compute this using just net income and depreciation. Review section 10.5.
[C] :You cannot compute this using just net income and depreciation. Review section 10.5.
[D] :You can compute only one of these using just net income and depreciation. Review section 10.5.
[E] :You can compute only one of these using just net income and depreciation. Review section 10.5.
68) The ________ is the present value of a project's costs calculated on an annual basis.
[A] internal rate of return

[B] average accounting return
[C] net present value
[D] equivalent annual cost
[E] profitability index
[A] :The IRR is reported as a percent, not as a present value. Review section 10.6.
[B] :The AAR is reported as a percent, not as a present value. Review section 10.6.
[C] :The NPV is not a present value on an annual basis. Review section 10.6.
[E] :The PI is a benefit to cost ratio, not a present value. Review section 10.6.
69) A project costs $60,000, will be depreciated straight-line to zero over its 4-year life, has a tax rate of 34 percent
and a required return of 10 percent. The project generates an operating cash flow of $18,000 and the fixed assets will
be sold for $7,000 at the termination of the project. What is the project's net present value?
[A] $213
[B] $1,133
[C] $1,839
[D] $2,261
[E] $2,842

[B] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section 10.3.
[C] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section 10.3.
[D] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section 10.3.
[E] :Did you get an after-tax cash flow of $4,620 from the sale of the fixed assets in year 4? Review section 10.3.
class life category. Assume a tax rate of 34 percent and a discount rate of 10 percent. What is the annual after-tax
maintenance cost?
[A] $10,000
[B] $12,250
[C] $13,200
[D] $15,250
[E] $27,200
[A] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section 10.3.
[B] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section 10.3.
[D] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section 10.3.
[E] :The pretax cost is $20,000 and the tax rate is 34 percent. Review section 10.3.
71) Assume a project requires additions to net working capital in each year of its life. All of the net working capital will
be recovered at the end of the project. In this case, the present value of the net working capital recovery will exceed
the total dollar outlays for net working capital.
[A] True
[B] False
[A] :Although the amount recovered will be the same as the amount invested, the present value of the amount
recovered will be lower due to discounting. Review section 10.4.
72) Which one of the following describes the "top-down" approach to computing operating cash flow?

[B] S - C - Taxes + D
[C] (S - C) X (1 - Tc) + D X Tc
[D] S - C - Taxes
[E] NI + D
[B] :This is not one of the ways of computing operating cash flow. Review section 10.5.
[E] :This is the bottom up approach. Review section 10.5.
73) When evaluating a capital budgeting project, you ignore all cash flows of the firm except those that change when
a project is implemented. You are focusing on the:
[A] capital expenditures.

[B] operating cash flows.
[C] incremental cash flows.
[D] non-cash expenses.
[E] opportunity costs.
[A] :This is partially correct, but there is a better choice. Review section 10.2.
[B] :This is partially correct, but there is a better choice. Review section 10.2.
[D] :Are you concentrating on the cash or the non-cash flows? Review section 10.2.
[E] :This is partially correct, but there is a better choice. Review section 10.2.
74) The bottom-up approach to finding operating cash flow works for any income statement.
[A] True
[B] False
[A] :If interest expense exists on the income statement, you should not use the bottom-up approach to find OCF.
75) Your company is considering three different methods of production: purchase production equipment, lease
production equipment, or contract with a supplier to purchase the product from them. The methods have differing
lives and cash flow streams. You are responsible for choosing one of the methods. Of the following, the best
statement of your objective is to choose the method that:
[A] will least affect the balance sheet of the company.

[B] maximizes future cash inflows.
[C] will result in the highest accounting net income.
[D] minimizes initial cash outflows.
[E] maximizes shareholder wealth.
[A] :How will this benefit the stockholders? Review section 10.1.
[B] :You can maximize cash inflows and still have a negative NPV project. Review section 10.1.
[C] :Since net income is not cash flow, this would likely be a poor choice. Review section 10.1.
[D] :You can minimize the initial cash outlay and still have a negative NPV project. Review section 10.1.
line over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent.
Suppose the equipment is sold at the end of year 3 for $20, pretax. What is the net present value? (Round to the
nearest whole dollar)
[A] $33
[B] $37
[C] $39
[D] $42
[E] $46
[A] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
sections 10.4 and 10.5.
[B] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
[C] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
[E] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
77) A firm moves into a higher tax bracket. All else equal, the depreciation tax shield will:
[A] be more valuable.

[B] be less valuable.
[C] remain unchanged since depreciation doesn't change.
[D] remain unchanged because changes in tax rates don't matter once a project is in place.
[E] be either more valuable, less valuable, or unchanged, but it is impossible to tell which without more information.

[B] :If the company moves into a higher tax bracket, the depreciation tax shield becomes more valuable. Review
section 10.5.
[C] :If one component of the tax shield rises, the tax shield has to rise. Review section 10.5.
[D] :The cash flows of a project change as the tax rate changes. Review section 10.5.
[E] :It is possible to tell. Review the tax shield computation in section 10.5.
78) The idea behind setting a bid price is to determine the minimum price at which the net present value of a project
will still be zero or positive.
[A] True
[B] False

[B] :The idea is to set the bid price so that shareholder wealth will not be destroyed. Review section 10.6.
79) You are considering the purchase of one of two machines required in your production process. Machine A has a
life of two years, costs $40 initially, and then $60 per year in maintenance. Machine B costs $70, and requires $45 in
maintenance for each year of its 3-year life. Both machines must be replaced at the end of their life. Which is the
better machine for the firm? The discount rate is 15 percent and the tax rate is zero.
[A] Machine A is better because its net present value is higher than the net present value of machine B.
[B] Machine A is better because its equivalent annual cost is -$60.24, which is less than the equivalent annual cost of
-$87.54 for machine B.
[C] Machine B is better because its equivalent annual cost is -$75.66, which is less than the equivalent annual cost of
-$90.12 for machine A.
[D] Machine B is better because its equivalent annual cost is -$75.66, which is less than the equivalent annual cost of
-$84.60 for machine A.
[E] Neither machine should be chosen since both have negative net present values.
[A] :While it is true that the NPV is higher for A, you cannot use the NPV to choose in this case since the two projects
have different lives and will be replicated forever. Review section 10.6.
[B] :Neither EAC is correct in this response. Review section 10.6.
[C] :The EAC is correct for B in this case, but incorrect for A. Review section 10.6.
[E] :This is a case where you have to choose the lowest cost production process. Review section 10.6.
line over 3 years to a salvage value of $0. Assume a 34 percent tax bracket and a discount rate of 15 percent.
Suppose the equipment is sold at the end of year 3 for $20, pretax. What is the internal rate of return?
[A] 16.3 percent

[B] 29.5 percent
[C] 33.6 percent
[D] 45.8 percent
[E] 62.7 percent
[A] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
[B] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
[D] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
[E] :Did you find the annual OCF to be $69.17 and the after-tax cash flow from salvage to be $13.20? Review
81) Your scientists just discovered that the engine-oil additive they developed three years ago makes a great men's
aftershave when diluted properly using certain chemicals. You are analyzing the proposal to commence production of
this after shave. For this analysis, the $125,000 that was spent doing research to develop the engine-oil additive
should be treated as:
[A] a cash outflow three years ago
[B] an initial investment today.
[C] an annual cost over the life of the project.
[D] an incremental cost.
[E] a sunk cost.
[A] :What is a sunk cost? Review section 10.2.

[B] :What is a sunk cost? Review section 10.2.
[C] :What is a sunk cost? Review section 10.2.
[D] :What is the difference between an incremental cost and a sunk cost? Review section 10.2.
82) A company which has a policy of "cash sales only" is considering allowing customers to buy on credit. Which one
of the following will probably occur if this change is implemented?
[A] sales will decrease

[B] there will be an immediate cash inflow
[C] accounts receivable will increase
[D] net working capital will decrease
[E] billing and collection expenses will decrease
[A] :Loosening credit terms will likely increase sales, not decrease them. Review section 10.4.
[B] :An increase in accounts receivable is a use of cash, not a source. Review section 10.4.
[D] :Accounts receivable will increase which increases net working capital. Review section 10.4.
[E] :These expenses will increase. Review section 10.4.
83) Your company may introduce a new line of tennis shoes. You have been given the following projections: sales =
35,000 units at $40 per unit; variable costs = $25 per unit; fixed costs = $125,000 per year; initial investment =
$1,000,000; project life = 10 years. What is the net income for this project if the corporate tax rate is 34 percent? You
may assume straight-line depreciation to a zero book value and a discount rate of 12 percent.
[A] $119,000
[B] $165,000
[C] $198,000
[D] $264,000
[E] $297,000
[A] :You need to review the construction of income statements in section 10.3.
[B] :You need to review the construction of income statements in section 10.3.
[D] :You need to review the construction of income statements in section 10.3.
[E] :You need to review the construction of income statements in section 10.3.
84) Suppose you purchase a machine for $14,000. The cost is depreciated straight-line to a salvage value of zero
over its 4-year life. If the machine is sold at the end of the third year for $6,000, what are the after-tax proceeds from
the sale assuming the tax rate is 34 percent?
[A] $1,010
[B] $3,960
[C] $5,010
[D] $5,150
[E] $6,990
[A] :Did you find the taxes to be $850 on a taxable gain of $2,500? Review section 10.4.
[B] :Did you find the taxes to be $850 on a taxable gain of $2,500? Review section 10.4.
[C] :Did you find the taxes to be $850 on a taxable gain of $2,500? Review section 10.4.
[E] :Did you find the taxes to be $850 on a taxable gain of $2,500? Review section 10.4.
85) Two types of batteries are being considered for use in electric golf carts. Burnout brand costs $36, have a 3-year
life, and cost $100 per year to charge. Longlasting brand costs $60 each, have a 5-year life, and cost $88 per year to
charge. The salvage value is zero in both cases. You must choose between the two and expect to replace them
forever. You should take the option with the:
[A] greater net present value.

[B] lower net present value.
[C] greater equivalent annual cost.
[D] smaller equivalent annual cost.
[E] lowest accounting break-even point.
[A] :Is it correct to use the NPV to choose when projects have different lives and are expected to be replicated
forever? Review section 10.6.
[B] :Is it correct to use the NPV to choose when projects have different lives and are expected to be replicated
forever? Review section 10.6.
[C] :Why would you choose an option with the greater equivalent annual cost? Review section 10.6.
[E] :Is it correct to use the accounting break-even point to choose when projects have different lives and are
expected to be replicated forever? Review section 10.6.
86) An increase in which of the following is a use of funds?

I. receivables
II. payables
III. inventory
IV. sales
[A] I and III only

[B] I and IV only
[C] II and III only
[D] II and IV only
[E] I, III, and IV only

[B] :One of these is a source of cash, not a use. Review section 10.4.
[C] :One of these is a source of cash, not a use. Review section 10.4.
[D] :Both of these are sources of cash, not uses. Review section 10.4.
[E] :At least one of these is a source of cash, not a use. Review section 10.4.
87) A sunk cost is:
[A] a cost that has already been incurred and cannot be removed.
[B] the same thing as an opportunity cost.
[C] the cash flows of a new project that come at the expense of existing projects.
[D] an important consideration in the capital budgeting process.
[E] a form of financing cost.

[B] :They are not the same; one is an incremental cash flow but the other is not. Review section 10.2.
[C] :This is the definition of erosion, not the definition of a sunk cost. Review section 10.2.
[D] :Sunk costs are not considered an incremental cash flow and are therefore irrelevant. Review section 10.2.
[E] :Interest and dividends are financing costs, sunk costs are not. Review section 10.2.
88) A decrease in the corporate tax rate decreases the value of the depreciation tax shield, all else equal.
[A] True
[B] False

[B] :Remember, the depreciation tax shield is equal to the depreciation multiplied by the tax rate. Review section
10.5.
89) Given the following information and assuming straight-line depreciation to zero, what is the IRR for this project?
Initial investment in fixed assets = $800,000; net working capital = $200,000; life = 4 years; cost savings = $400,000
per year; salvage = $100,000 in year 4; tax rate = 35 percent; discount rate = 12 percent.
[A] 12.0 percent

[B] 13.6 percent
[C] 14.8 percent
[D] 18.4 percent
[E] 19.1 percent
[A] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
plus $65,000 for the after-tax salvage value? Review section 10.3.
[B] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
[C] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
[D] :Did you get OCF of $330,000 per year and a terminal cash flow of $200,000 for recovery of net working capital
90) A taxable gain occurs when an asset is sold for more than its book value. For capital budgeting purposes, the
taxes on the sale are treated as a:
[A] reduction in cash and added to operating cash flow.

[B] noncash event similar to depreciation.
[C] reduction in cash and deducted from the book value of the asset.
[D] reduction in cash and deducted from the taxable gain.
[E] reduction in cash and deducted from the sale price.
[A] :A reduction in cash should not be added to operating cash flow. Review section 10.3.
[B] :Taxes are a cash expense that must be considered. Review section 10.3.
[C] :The resulting reduction in cash should be deducted from the market value, not the book value. Review section
10.3.
[D] :The resulting reduction in cash should be deducted from the market value, not the taxable gain. Review section
10.3.
91) You are considering a new project that will require an initial build up of raw materials inventory. The expected life
of the project's equipment is seven years. If all goes as you expect, you will replace the equipment at the end of the
seven years. If not, you will terminate the project. You currently believe there is a fifty-fifty chance of either
occurrence. How should you treat the raw material inventory in year seven of your present analysis and why?
[A] treat half of it as a cash inflow because there is a 50 percent chance the project will terminate then
[B] treat it as a cash outflow because it is expected that the machines will be replaced
[C] treat it as a cash inflow because the replacement of the machines becomes a new capital budgeting decision at
that point
[D] treat it as both a cash inflow and outflow with a net effect zero
[E] treat half as a cash inflow in year seven, but also treat only half as a cash outflow at the beginning of the project
[A] :The inventory should be recouped at the end of seven years. If new equipment is purchased, that is a new
capital budgeting process and needs to be analyzed as such. Review section 10.4.
[B] :The inventory should be recouped at the end of seven years. If new equipment is purchased, that is a new
[D] :The inventory should be recouped at the end of seven years. If new equipment is purchased, that is a new
[E] :The inventory should be recouped at the end of seven years. If new equipment is purchased, that is a new
92) A project costs $40,000, will be depreciated straight-line to zero over its 3-year life, will require a net working
capital investment of $5,000 up front, has a tax rate of 34 percent and a required return of 10 percent. The fixed
assets will be worthless at the end of the project. The project generates an operating cash flow of $17,000. What is
the project's net present value rounded to the nearest whole dollar?
[A] -$2,724
[B] $1,033
[C] $1,393
[D] $2,394
[E] $2,942
[A] :It appears you have ignored the recovery of the net working capital at the end of the project. Review section
10.4.
[C] :Remember, the investment in net working capital is an outflow at the start and an inflow at the end of the project.
[D] :Remember, the investment in net working capital is an outflow at the start and an inflow at the end of the project.
[E] :Remember, the investment in net working capital is an outflow at the start and an inflow at the end of the project.
93) Net working capital is expected to increase from $1,000 to $1,500 if a new project is implemented. The $500
increase should be included as a part of the initial outlay for the new project.
[A] True
[B] False

[B] :The increase in net working capital represents a net purchase of assets which should be considered as part of
the initial investment for the new project. Review section 10.4.
94) Which one of the following is least likely to cause erosion?
[A] A gas station owner expands his building to make room for a convenience store.
[B] You begin selling coffee in new, smaller-sized foil pouches along side your regular sizes of coffee cans.
[C] You build a Taco Bell just down the street from your McDonalds.
[D] Your grocery store begins to carry additional flavors of ice cream.
[E] The concession stand at the local ball field begins to sell both hot dogs and hamburgers rather than just hot dogs.

[B] :Wouldn't you expect the new coffee to steal some of the existing sales of your old coffee? Review section 10.2.
[C] :Wouldn't you expect the new Taco Bell to steal some of the existing sales from McDonalds since they are
located on the same street? Review section 10.2.
[D] :Will people now buy two gallons of ice cream instead of just one? Review section 10.2.
[E] :Will all of the fans now purchase both a hamburger and a hot dog? Review section 10.2.
equipment will be replaced as it wears out, that you can only buy one of the machines, and that straight-line
depreciation to zero is used. The required return is 15 percent. Ignore taxes. Machine A has an initial cost of
$200,000, an operating cost per year of $15,000, and an expected life of 8 years. Machine B has an initial cost of
$300,000, an operating cost per year of $17,500, and an expected life of 10 years. Which machine should you buy
and why?
[A] Machine A; because it has a higher net present value

[B] Machine A; because it effectively costs less to operate each year
[C] Machine B; because it has a higher net present value
[D] Machine B; because it effectively costs less to operate each year
[E] Neither; because both machines have negative net present values
[A] :Machine A does have the higher NPV of the two, but you should rank the projects using EAC in this case since
they have differing lives. Review section 10.6.
[C] :Machine B does not have the higher NPV of the two. Even so, you should rank the projects using EAC in this
case since they have differing lives. Review section 10.6.
[D] :Machine B costs more to operate than Machine A if you compute the EACs of the two projects correctly. As a
preliminary step, did you get an NPV of -$267,310 for A and an NPV of -$387,828 for? Review section 10.6.
[E] :The two do have negative NPVs, but the machines are required for your business so you must pick the least-
cost alternative. Review section 10.6.
96) Which of the following describes project cash flow?

I. OCF - additions to NWC - capital spending
II. OCF + additions to NWC + capital spending
III. OCF + additions to NWC - capital spending
IV. OCF + reductions in NWC - capital spending
[A] III and IV only

[B] I and III only
[C] I and IV only
[D] II and III only
[E] I, II, III and IV
[A] :At least one of these choices is incorrect. Review section 10.3.
[B] :At least one of these choices is incorrect. Review section 10.3.
[D] :At least one of these choices is incorrect. Review section 10.3.
[E] :At least one of these choices is incorrect. Review section 10.3.
97) Which of the following can be depreciated for tax purposes?
I. machinery and equipment
II. land
III. buildings
[A] I only
[B] I and II only
[C] I and III only
[D] II and III only
[E] I, II, and III
[B] :At least one of these is incorrect. Review section 10.4.
[D] :At least one of these is incorrect. Review section 10.4.
[E] :At least one of these is incorrect. Review section 10.4.
98) The managers of Poncho Parts, Inc. plan to manufacture engine blocks for classic cars from the 1960s. They
expect to sell 250 blocks annually for the next 5 years. The necessary foundry and machining equipment will cost a
total of $800,000 and will be depreciated on a straight-line basis to zero over the project's life. The firm expects to be
able to sell the equipment for $150,000 at the end of 5 years. Labor and materials costs total $500 per engine block,
fixed costs are $125,000 per year. Assume a 35 percent tax rate and a 12 percent discount rate. What will be the
annual depreciation tax shield?
[A] $20,000
[B] $56,000
[C] $100,000
[D] $104,000
[E] $120,000
[A] :Did you find the annual depreciation to be $160,000? Review section 10.5.
[C] :Did you find the annual depreciation to be $160,000? Review section 10.5.
[D] :Did you find the annual depreciation to be $160,000? Review section 10.5.
[E] :Did you find the annual depreciation to be $160,000? Review section 10.5.
99) Which of the following allow you to compute operating cash flow without actually knowing the dollar amount of
depreciation?
I. bottom-up approach
II. top-down approach
III. tax shield approach
[A] I only
[B] II only
[C] III only
[D] II and III only
[E] I, II, and III
[A] :You need to know depreciation to use this approach since you need to add depreciation back. Review section
10.5.
[C] :You need to know depreciation to use this approach since you need to add the depreciation tax shield back.
[D] :You need to know depreciation to use at least one of these two approaches. Review section 10.5.
[E] :You need to know depreciation to use at least one of these three approaches. Review section 10.5.
100) According to the stand-alone principle, a project should be evaluated based on the project's incremental cash
flows.
[A] True
[B] False

[B] :This is the definition of the stand-alone principle. Review section 10.1.
101) A machine costs $60 and requires $35 in maintenance for each year of its 3-year life. After 3 years, this
machine will be replaced. Suppose that the machine is depreciable straight-line over its three-year life to a salvage
value of zero and the machine will be worthless at that time. Assuming a tax rate of 34 percent and a discount rate of
14 percent, what is the EAC for the machine?
[A] -$39.48
[B] -$42.14
[C] -$48.33
[D] -$59.13
[E] -$97.84
[A] :To solve this, you must first find the NPV. Did you get operating cash flow of -$16.30 and an NPV of -$97.84?
[C] :To solve this, you must first find the NPV. Did you get operating cash flow of -$16.30 and an NPV of -$97.84?
[D] :To solve this, you must first find the NPV. Did you get operating cash flow of -$16.30 and an NPV of -$97.84?
[E] :This is the NPV. Now you need to convert this into an annuity. Review section 10.6.
102) Your company currently sells oversized golf clubs. The board of directors wants you to look at replacing them
with a line of super-sized clubs. Which one of the following should NOT be included in an analysis of this proposed
project?
[A] $300,000 drop in sales from terminating the oversized line of clubs
[B] $750,000 in land you own that may be used for the project
[C] $200,000 spent on research and development last year on oversized clubs
[D] $350,000 you will pay to Fred Singles to promote your new clubs
[E] $125,000 you will receive by selling the existing production equipment which must be replaced
[A] :This would be erosion, would it not? Review section 10.2.

[B] :There would be an opportunity cost here, would there not? Review section 10.2.
[D] :This would be a cash outlay that is directly related to the project, would it not? Review section 10.2.
[E] :This is a cash flow that results directly from taking the project and is therefore an incremental cash flow. Review
section 10.2.
103) If the assets of a project can be sold for an amount exactly equal to their book value during the life of a project,
the cash flow from the sale will be zero and can therefore be ignored when analyzing a project.
[A] True
[B] False
[A] :There will be no taxable gain and therefore no tax consequences. However, the sales price is a cash inflow
which should be included in the project analysis. Review section 10.4.

Questions Chapter 10

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Questions Chapter 10

1) Side effects such as erosion should be considered in a capital budgeting decision.

[A] :You are correct!

[A] :You are correct!

4) A sunk cost is an incremental cash flow.

[A] :You are correct!

[A] 6.25 percent

[A] :You are correct!

10) Which of the following statements are correct?

[A] III only

[A] EBIT + D - Taxes

12) Consider the following balance sheet entries:

[A] :You are correct!

[A] 2.5 years

[A] :What about the opportunity cost? Review section 10.2.

[A] the stand-alone principle

[A] :You are correct!

[A] discounted payback

[A] the stand-alone principle

31) Which one of the following is correct concerning project evaluation?

[A] EBIT + D - Taxes

[A] opportunity cost

[A] because they are the simplest to identify.

[A] more than 3.0 but less than 3.5 years

[A] sunk costs exist.

39) Pro forma statements:

[A] are generally created by first estimating production costs.

[A] :You are correct!

[A] AAR = required return

[A] :You are correct!

[A] selling price and the original purchase price.

43) Consider the following balance sheet entries:

[A] :You are correct!

[A] :What about depreciation? Review section 10.5.

[A] sales will increase

[A] :You are correct!

[A] equal; never be replaced.

53) Consider the following balance sheet entries:

[A] I and III only

[A] going to earn a net income of zero on the project.

[A] EBIT + D - Taxes

60) Sunk cost is another term which describes opportunity cost.

[A] accounts payable

[A] :You are correct!

[A] :You are correct!

[A] purchasing land for a new baseball manufacturing plant

[A] :You are correct!

[A] internal rate of return

[A] :You are correct!

[A] EBIT + D - Taxes

[A] capital expenditures.

[A] will least affect the balance sheet of the company.

[A] be more valuable.

[A] :You are correct!

[A] :You are correct!

[A] 16.3 percent

[A] :What is a sunk cost? Review section 10.2.

[A] sales will decrease

[A] greater net present value.

86) An increase in which of the following is a use of funds?

[A] I and III only

[A] :You are correct!

87) A sunk cost is: