Quiz no.

2 -FINMAN 412 (Chapters 12-14)

Name:________________________________________ Date:______________
I. Write T or F beside the number.T if the Statement is true and F if the statement is false.

1. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of
capital (its WACC) f

2. Because "present value" refers to the value of cash flows that occur at different points in time, a
series of present values of cash flows should not be summed to determine the value of a capital
budgeting project.f

3. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose
cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV
of a project whose cash flows come in later in its life.f

4. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should
be accepted.f

5. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks
one project higher but the IRR method puts the other one first. In theory, such conflicts should be
resolved in favor of the project with the higher NPV.t

6. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks
one project higher but the IRR method puts the other one first. In theory, such conflicts should be
resolved in favor of the project with the higher IRR.f

7. The internal rate of return is that discount rate that equates the present value of the cash outflows
(or costs) with the present value of the cash inflows.t

8. Other things held constant, an increase in the cost of capital will result in a decrease in a project's
IRR.f

9. Under certain conditions, a project may have more than one IRR. One such condition is when, in
addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the
project's life.t

10. The phenomenon called "multiple internal rates of return" arises when two or more mutually
exclusive projects that have different lives are being compared.f

11. Because of improvements in forecasting techniques, estimating the cash flows associated with a
project has become the easiest step in the capital budgeting process.f

12. Estimating project cash flows is generally the most important, but also the most difficult, step in the
capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so
than obtaining a reasonably accurate estimate of projects' cash flows.t

13. Although it is extremely difficult to make accurate forecasts of the revenues that a project will
generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is
especially true for large product development projects.f

14. Since the focus of capital budgeting is on cash flows rather than on net income, changes in
noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis.f

15. If an investment project would make use of land which the firm currently owns, the project should
be charged with the opportunity cost of the land.t

16. If debt is to be used to finance a project, then when cash flows for a project are estimated, interest
payments should be included in the analysis.f

17. Any cash flows that can be classified as incremental to a particular project—i.e., results directly
from the decision to undertake the project—should be reflected in the capital budgeting analysis.t

18. We can identify the cash costs and cash inflows to a company that will result from a project. These
could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there
are other costs and benefits that do not flow from or to the firm, but to other parties, these are called
externalities, and they need not be considered as a part of the capital budgeting analysis.f

19. In cash flow estimation, the existence of externalities should be taken into account if those
externalities have any effects on the firm's long-run cash flows.t

20. Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be
quantified with any precision—estimates of its effect would really just be guesses. In this case, the
externality should be ignored—i.e., not considered at all—because if it were considered it would make
the analysis appear more precise than it really is.f

21. Real options are valuable, and that value is correctly captured by a traditional NPV analysis.
Therefore, there is no reason to consider real options separately from the NPV analysis.f

22. Real options are most valuable when the underlying source of risk--such as uncertainty about unit
sales, or the sales price, or input costs--is very low.f

23. Real options can affect the size of a project's expected NPV but not project's risk as measured by
the standard deviation or coefficient of variation of the NPV.f

24. Real options exist whenever managers have the opportunity, after a project has been
implemented, to make operating changes in response to changed conditions that modify the project's
cash flows.t

25. Traditional discounted cash flow (DCF) analysis--where a project's cash flows are estimated and
then discounted to obtain an expected NPV--has been the cornerstone of capital budgeting since the
1950s. However, in recent years, it has been demonstrated that DCF techniques do not always lead to
proper capital budgeting decisions due to the existence of real options.t

26. Real options are options to buy real assets, especially stocks, rather than interest-bearing assets,
like bonds.f

27. The following are all examples of real options that are discussed in the text: (1) growth options, (2)
flexibility options, (3) timing options, and (4) abandonment options.t

28. The following are all examples of real options that are discussed in the text: (1) protection options,
(2) flexibility options, (3) timing options, and (4) abandonment options.f

29. The following are all examples of real options that are discussed in the text: (1) natural resource
options, (2) flexibility options, (3) timing options, and (4) abandonment options.f

30. The option to abandon a project is a real option, but a call option on a stock is not a real option.t

II. Encircle the letter of the best answer.Show your solutions at the back.

Items 31 and 32 are based on the following information:

Fleming, Inc. is planning to acquire a new machine at a total cost of 360,000. The estimated life of the
machine is six years with no salvage value. The straight-line method of depreciation will be used.
Fleming estimates that the annual cash flow from operations, before income taxes, from using this
machine amounts to 90,000. Assume that Fleming's cost of capital is 8% and the income tax rate is
40%. The present value of 1 at 8% for six years is 0.630. The present value of an annuity of 1 in
arrears at 8% for six years is 4.623.

31. What would be the payback period for the machine?

a. 4.0 years b. 4.6 years c. 5.7 years d. 6.7 years

32. What would be the net present value?

a. 590 b. 56,070 c. 108,000 d. 131,400

33. Rosa Company is planning to invest 40,000 in a three-year project. Rosa's expected rate of return
is 10%. The present value of 1 at 10% for one year is .909, for two years is .826, and for three years
is .751. The cash flow, net of income taxes will be 20,000 a year for each of the first three years of the
payback period and 30,000 a year for each of the last three years of the payback period. Depreciation
of 15,000 a year will be charged to income for each of the six years of the payback period.
How much will the machine cost?
a. 150,000 b. 120,000 c. 90,000 d. 60,000

34. The Herb Company acquired a new machine for 160,000 that will be depreciated on a straight-line
basis over ten-year period. A full year's depreciation was taken in the year of acquisition. The
accounting (book value) rate of return is expected to be 12% on the initial increase in required
investment.
If we assume a uniform cash inflow, the annual cash flow from operations, net of income taxes, will be
a. 3,200 b. 17,280 c. 19,200 d. 35,200

35. Fillmore, Inc. is planning a project that will cost 220,000. The annual cash inflow, net of income
taxes, will be 50,000 a year for seven years. The present value of 1 at 12% is as follows:
Period PV of 1 at 12% Period PV of 1 at 12%
1 .893 5 .567
2 .797 6 .507
3 .712 7 .452
4 .636

Using a rate of return of 12%, what is the present value of the cash flow generated by this project?
a. 226,000 b. 228,200 c. 341,800 d. 350,000

36. Ludwig, Inc. purchased a new machine on January 1, 20CY for 350,000. The machine is expected
to have a useful life of 8 years and no salvage value. Straight-line depreciation is to be used. The
present value of the cash flow generated by the machine was calculated to be 371,120 using a time-
adjusted rate of return of 14%. The present value of an ordinary annuity of 1 in arrears for 8 periods at
14% is 4.639. The present value of 1 for 8 periods at 14% is 0.351. What was the annual cash flow,
net of income taxes, that was used in the calculation of the present value?
a. 122,850 b. 75,447 c. 130,263 d. 80,000

37. Maxwell Company has an opportunity to acquire a new machine to replace one of its present
machines. The new machine would cost 90,000; have a five-year life and no estimated salvage value.
Variable operating costs would be 100,000 per year. The present machine has a book value of 50,000
and a remaining life of five years. Its disposal value now is 5,000, but it would be zero after five years.
Variable operating costs would be 125,000 per year. Ignore present value calculations and income
taxes.(bonus because of clerical error)
Considering the five years in total, what would be the difference in profit before income taxes by
acquiring the new machine as opposed to retaining the present one?
a. 10,000 decrease c. 35,000 increase
b. 15,000 decrease d. 40,000 increase

Items 38 and 39 are based on the following information:

Heflin, Inc. invested in a machine with a useful life of five years and no salvage value. The machine
was depreciated using the straight-line method. The annual cash inflow from operations, net of income
taxes, amounts to 100,000. The present value of an ordinary annuity of 1 in arrears for five years at
12% is 3.605. The present value of 1 for five years as 12% is 0.567

38. Assuming that Heflin used a time-adjusted rate of return of12%, what was the amount of the
original investment?
a. 283,500 b. 360,500 c. 440,000 d. 567,000

39. Assuming that the minimum desired rate of return on this investment was 12% and the amount of
the original investment was 350,000, what would be the net present value?
a. 0 b. 10,500 c. 19,800 d. 5,670

40. Coral Inc, recently acquired a machine at a cost of 64,000. It will be depreciated on a straight-line
basis over eight years with no estiamted salvage value. Coral estimates that this machine will produce
annual net cash flow (before income taxes) of 18,000. Assuming an income tax rate of 50%,what is
the approximate payback period on this investment?
a. 3.6 years b. 4.9 years c. 7.1 years d. 12.8 years

41. Freedom Corporation acquired a fixed asset at a cost of 100,000. The estimated life was four
years and there was no estimated salvage value. Assume a relevant interest rate of 8% and an
income tax rate of 40%. The present value of 1 at 8% is as follows:
No. of periods Present value No. of periods Present value
1 .926 3 .794
2 .857 4 .735
What is the present value of the tax benefits resulting from using the sum-of-the-years' digits
depreciation as opposed to straight-line depreciation on this asset?
a. 0 b. 1,908 c. 1,272 d. 3,180

42. George Company is planning to acquire a new machine at a total cost of 306,000. The estimated
life of the machine is six years and the estimated salvage value is 6,000. George Company estimates
annual cash savings from using this machine will be 80,000. Assume the company's cost of capital is
8% and its income tax rate is 40%. The present value of 1 for six years is .630. The present value of
an annuity of 1 in arrears at 8% for six years is 4.623. What are the annual after tax cash benefits of
this investment?
a. 30,000 b. 48,000 c. 54,000 d. 68,000

43. Assuming the same information as in No. 20, if the annual after tax net cash benefits of this
investment were 50,000, what would the net present value of this investment be?
a. 74,850 negative c. 71,070 positive
b. 71,070 negative d. 74,850 positive

44. Assuming with the same information in No. 20, if the annual after tax net cash benefits of the
investment were 50,000, what would be the payback period?
a. 6.0 years b. 6.12 years c. 5.5 years d. 4.4 years

45. Jarvis Inc., a calendar year company, purchased a new machine for 280,000 on January 1. 20CY.
The machine has an estimated useful life of eight years with no salvage value and is being
depreciated using the straight-line method. The accounting (book value) rate of return is expected to
be 15% on the initial increase in required investment.
On the assumption of a uniform cash inflow, this investment is expected to provide annual cash flow
from operations , net of income taxes, of
a. 35,000 b. 40,250 c. 42,000 d. 77,000

46. Energy Company is planning to spend 840,000 for a new machine that it will be depreciated on a
straight line basis over ten years with no salvage value. The related cash flow from operations,net of
income taxes, is expected to be 100,000 a year for each of the first six years and 120,000 for each of
the next four years
What is the payback period?
a. 4.4 years b.7.6 years c. 7.8 years d. 8.0 years

47.Hilltop Company invested 100,000 in a two-year project. Hilltop's expected rate of return was 12% .
The cash flow, net of income taxes,was 40,000 for the first year. Information on present value and
future value factors is as follows:
Present Value Future Value
Period of 1 at 12% of 1 at 12%
1 .8929 1.1200
2 .7972 1.2544
Assuming that the tax rate of return was exactly 12%, what was the cash flow, net of income taxes ,
for the second year of the project ?
a. 51,247 b. 50,000 c. 64,284 d. 80,638

48. The Bread Company is planning to purchase a new machine that it will depreciate on a straight-
line basis over a ten-year period. A full year's depreciation will be taken in the year of acquisition. The
machine is expected to produce cash flow, net of income taxes, of 30,000 in each of the ten years.
The accounting (book value) rate of return is expected to be 10% on the initial increase in required
investment. The cost of the new machine will be
a. 120,000 b. 135,000 c. 150,000 d. 300,000

49.The Polar Company is planning to purchase a new machine for 300,000. The payback period is
expected to be five years. The new machine is expected to produce cash flow from operations, net of
income taxes, of 70,000 a year in each of the next three years and 55,000 in the fourth year.
Depreciation of 50,000 a year will be charged to income for each of the five years of the payback
period. What is the amount of cash flow from operations, net of taxes, that the new machine is
expected to produce in the last (fifth) year of the payback period?
a. 10,000 b. 35,000 c. 50,000 d. 85,000
50. SM Supply is considering the purchase of a new machine. The expected after-tax cash flows are
listed as follows:
Year Cash Flows After Taxes
1 20,000
2 30,000
3 30,000
4 20,000
5 10,000
If SM requires a target fate of 18% on investment of this type, the maximum SM should pay for this
machine is
a. 110,000 b. 120,000 c. 65,660 d. 71,440

51. Oriental Books is considering the purchase of new binding equipment that will reduce operating
costs. The cost of the equipment will be 70,000, which will be depreciated straight-line over five years
to a zero salvage value. Sales are expected to increase 65,000 per year, with expected cash flow
earnings before depreciation and, taxes/sales ratio of 60%.
The tax rate is 40%, after tax cash flows from the project are expected to be
a. 25,000 b. 15,000 c. 15,000 d. 29,000

52. The Top Company is considering purchasing a new truck that will cost 700,000 and will be
derpeciated over five years. The new truck will replace another that has a book value of 450,000 and
five years useful life remaining. The old truck can be sold for 400,000. The current tax rate is 35%.
The net initial investment for the new truck is
a. 300,000 b. 250,000 c. 282,500 d. 317,500

ACCROCHEZ VOUS!!!

Solutions for problems:

31. b. Annual cash flow before taxes 90,000 90,000

Less Depreciation: (360,000/6) 60,000
Taxable Income 30,000
Income Tax x 40% 12,000
Annual cash flow after taxes 78,000

Payback Period: (360,000/78,000) 4.6 years

32. a. Present value of cash flow after taxes (78,000 x 4.623) 360,590
Cost of Machine 360,000
Net Present Value 590

33. a. Cash flow, net of tax: Years 1-3 (20,000 x 3) 60,000

Years 4-6 (30,000 x3) 90,000
Cost of Machine 150,000

34. d. Investment (160,000 x 12%) = 19,200

+ Depreciation (160k/10) = 16,000
Annual cash flow 35,200

35. b.Present value of cash flows,net of tax (50,000 x 4.564) = 228,200

36. d. Present value of cash flow at 14% 371,120

Present value of an annuity for 8 periods / 4.639
Annual cash Flow 80,000

37. d. Net cost of new machine: (90,000-5,000) 85,000

Operating costs: (100,000 x 5) 500,000
Total 585,000
Operating costs of old machine (125,000 x 5) 625,000
Increase in Profit 40,000
 38. b. Original Investment: (100,000 x 3.605) 360,500
39. b. Present value of cash flows, net of taxes: (100,000 x 3.605) 360,500
Initial investment 350,000
Net present value 10,500

40. b. Annual cash flow before taxes 18,000 18,000

Less: Depreciation (64,000/8) 8,000
Taxable income 10,000
Income Tax 50% ( 5,000)
annual cash flow after income tax 13,000
Payback period: (64,000/ 13,000) 4.9 years

41. c Year SYD S.Line Diff. PV Factor Present value

1 40,000 25,000 15,000 .926 13,890
2 30,000 25,000 5,000 .857 4,285
3 20,000 25,000 (5,000) .794 (3,970)
4 10,000 25,000 (15,000) .735 (11,025)
3,180
Tax (40%) 40%
Tax benefits 1,272

42. d. Annual cash savings before tax 80,000 80,000

Less Depreciation : (306,000-6,000)/6 50,000
Taxable Income 30,000
Income Tax x 40% (12,000)
Cash savings after tax 68,000

43. b.Present value of annual cash savings : (50,000 x 4.623) 231,150

Present value of salvage value ( 6,000 x .630) 3,780
Total present value 234,930
Initial investment 306,000
Present value – negative (71,070)

44. b. Payback period: (306,000/ 50,000) = 6.12 years

45. d. Accounting Rate of return: (*X-280,000/8)=15%

280,000
*X-35,000+42,000 X = 77,000 Annual cash flow

46. d. Cash flow net of tax: Year 1-6 (100,000 x 6) 600,000

Year 7-8 (120,000 x 2) 240,000
Equal to Initial investment 840,000
Therefore the payback period is 8 years

47. d. Initial investment 100,000

Present value, of cash flow: Year 1(40,000 x .8929) 35,716
Present value of cash flow -Year 2 64,284
To convert to future value of Year 2 cash flow x 1.2544
Cash flow – Year 3 80,638

48. c. Cost of the Machine: 30,000- (X/10) = 10%

X*
.10X = 30,000- (X/10)
.20X = 30,000 X = 150,000

49. b. Initial investment 300,000

Cash flows: Year 1-3 (7,000 x 3) 210,000
Year 4 55,000 265,000

Cash flow: Year 5 35,000

.
50. d. Year PV * “ 18% Cash flows Present value
1 .847 20,000 16,940
2 .718 30,000 21,540
3 .609 30,000 18,270
4 .516 20,000 10,320
5 .436 10,000 4,360
SM should pay 71,430

51. d. Annual Cash flow before taxes: (65,000 x 60%) 39,000 39,000
Less depreciation: (70,000/5) 14,000
Taxable income 25,000
Income tax x 40% 10,000
After-tex cash flows 29,000

52.c. Cost of New Truck 700,000

Less: Disposal of old truck 400,000
Tax savings on loss-old truck (50,000 x 35%) 17,500 417,500
Net initial Investment 282,500