Deck 6: Making Investment Decisions With the Net Present Value Rule

Question 1

If the discount rate is stated in nominal terms, then in order to calculate the NPV in a consistent manner requires that project:
I. cash flows be estimated in nominal terms
II. cash flows be estimated in real terms
III. accounting income be used

A) I only
B) II only
C) III only
D) None of the above

Answer 1

I only

Question 2

A reduction in the sales of existing products caused by the introduction of a new product is an example of:

A) incidental effects
B) opportunity cost
C) sunk cost
D) none of the above

Answer 2

incidental effects

Question 3

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

A) Firms must invest cash in short-term assets to produce finished goods
B) They are sunk costs
C) Firms need positive NPV projects for investment
D) None of the above

Answer 3

Firms must invest cash in short-term assets to produce finished goods

Question 4

Money that a firm has already spent or committed to spend regardless of whether a project is taken is called:

A) Fixed cost
B) Opportunity cost
C) Sunk cost
D) None of the above

Question 5

The cost that is incurred as a result of past, irrevocable decisions and is irrelevant to future decisions is called:

A) Opportunity cost
B) Sunk cost
C) Incremental cost
D) None of the above

Question 6

For example, when Honda develops a new engine, the incidental effects might include the following:
I. demand for replacement parts
II. profitable service facilities
III. offer modified or improved versions of the engine for other uses

A) I only
B) I and II only
C) I,II, and III
D) None of the given ones

Question 7

The principal short-term assets are:
I. Cash
II) Accounts receivable
III) Inventories,
IV) Accounts Payable

A) I only
B) I and IV only
C) I, II, and III
D) IV only

Question 8

A firm owns a building with a book value of $150,000 and a market value of $250,000. If the building is utilized for a project, then the opportunity cost ignoring taxes is:

A) $100,000
B) $150,000
C) $250,000
D) None of the above

Question 9

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

A) book value
B) market value
C) historical value
D) none of the above

Question 10

For example, in case of an electric car project, the following cash flows should be treated as incremental flows when deciding whether to go ahead with the project except:

A) The consequent reduction in sales of the company's existing gasoline models (i.e.: incidental effects)
B) Interest payment on debt
C) The value of tools that can be transferred from the company's existing plants
D) The expenditure on new plants and equipment

Question 11

Investment in inventories includes investment in:
I) Raw material
II) Work-in-progress
III) Finished goods

A) I only
B) I and II only
C) I, II, and III
D) III only

Question 12

If the discount rate is stated in real terms, then in order to calculate the NPV in a consistent manner requires that project:
I. cash flows be estimated in nominal terms
II. cash flows be estimated in real terms
III. accounting income be used

A) I only
B) II only
C) III only
D) None of the above

Question 13

Preferably, cash flows for a project are estimated as:

A) Cash flows before taxes
B) Cash flows after taxes
C) Accounting profits before taxes
D) Accounting profits after taxes

Question 14

For example, in the case of an electric car project, which of the following cash flows should be treated as incremental flows when deciding whether to go ahead with the project?

A) The cost of research and development undertaken for developing the electric car in the past three years
B) The annual depreciation charge
C) Tax savings resulting from the depreciation charges
D) Dividend payments

Question 15

The cost of a resource that may be relevant to an investment decision even when no cash changes hand is called a (an):

A) Sunk cost
B) Opportunity cost
C) Working capital
D) None of the above

Question 16

Investment in net working capital is not depreciated because:

A) It is not a cash flow
B) It is recovered during or at the end of the project and is not a depreciating asset
C) It is a sunk cost
D) All of the above

Question 17

Net Working Capital is the:
I. short-term assets
II. short term liabilities
III. long-term assets
IV. long term liabilities

A) I only
B) (I - II)
C) (III - I)
D) (III - IV)

Question 18

The value of a previously purchased machine to be used by a proposed project is an example of:

A) Sunk cost
B) Opportunity cost
C) Fixed cost
D) None of the above

Question 19

When a firm has the opportunity to add a project that will utilize excess factory capacity (that is currently not being used), which costs should be used to determine if the added project should be undertaken?

A) Opportunity cost
B) Sunk cost
C) Incremental costs
D) None of the above

Question 20

Important points to remember while estimating cash flows of projects are:
I. only cash flow is relevant
II. always estimate cash flows on an incremental basis
III. be consistent in the treatment of inflation

A) I only
B) I and II only
C) II, and III only
D) I,II, and III

Question 21

A project requires an initial investment of $200,000 and is expected to produce a cash flow before taxes of 120,000 per year for two years. [i.e. cash flows will occur at t = 1 and t = 2]. The corporate tax rate is 30%. The assets will be depreciated using MACRS - 3 year schedule: (t=1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can make use of all applicable tax shields. The opportunity cost of capital is 12%. Assume that the asset can be sold for book value. Calculate the NPV of the project: (Approximately)

A) $22,463
B) $19,315
C) $16,244
D) None of the above

Question 22

Working capital is one of the most common causes of misunderstanding in estimating project cash flows. The following are the most common errors:
I. forgetting about working capital entirely
II. forgetting that working capital may change during the life of the project
III. forgetting that working capital is recovered at the end of the project
IV. forgetting to depreciate the working capital

A) I and II only
B) I, II, and III only
C) II,III and IV only
D) I,II and IV only

Question 23

Given the following data for Project M:
$\begin{array}{c}\begin{array}{lll}\\ \text {Cash flow in nominal terms:}\\\text {Real discount rate \( =\mathbf{5} \% \)}\\\text {Nominal discount rate \( =10 \% \)}\\\text {Calculate the NPV of the project}\end{array}\begin{array}{lll}C_{0} & C_{1} & C_{2} \\-100 & 75 & 60\\\\\\\\\end{array}\end{array}$

A) $25.85
B) $17.77
C) $22.65
D) None of the above

Question 24

A capital equipment costing $400,000 today has no (zero) salvage value at the end of 5 years. If straight-line depreciation is used, what is the book value of the equipment at the end of three years?

A) $120,000
B) $80,000
C) $160,000
D) $240,000

Question 25

A firm has a general-purpose machine, which has a book value of $300,000 and is sold for $500,000 in the market. If the tax rate is 35%, what is the opportunity cost of using the machine in a project?

A) $500,000
B) $430,000
C) $300,000
D) None of the above

Question 26

A cash flow received in two years is expected to be $10,816 in nominal terms. If the real rate of interest is 2% and the inflation rate is 4%, what is the real cash flow for year-2?

A) $11,236
B) $10,816
C) $10,000
D) $9,246

Question 27

The real rate of interest is 3% and the inflation is 4%. What is the nominal rate of interest?

A) 3%
B) 4%
C) 7.12%
D) 1%

Question 28

For project Z, year-5 inventories increase by $6,000, accounts receivables by $4,000 and accounts payables by $3,000. Calculate the increase or decrease in working capital for year-5.

A) Increases by $6,000
B) Decreases by $4,000
C) Increases by $7,000
D) Decreases by $7,000

Question 29

If the depreciation amount is 600,000 and the marginal tax rate is 35%, then the tax shield due to depreciation is:

A) $210,000
B) $600,000
C) $390,000
D) None of the above

Question 30

If the depreciable investment is $600,000 and the MACRS 5-Year class schedule is: Year-1: 20%; Year-2: 32%; Year-3: 19.2%; Year-4: 11.5%; Year-5: 11.5% and Year-6: 5.8% Calculate the depreciation for Year-2.

A) $120,000
B) $192,000
C) $96,000
D) $115,200

Question 31

The real interest rate is 3% and the inflation rate is 5%. What is the nominal interest rate?

A) 3%
B) 5%
C) 8.15%
D) 2%

Question 32

If the depreciation amount is $100,000 and the marginal tax rate is 35%, then the tax shield due to depreciation is:

A) $35,000
B) $100,000
C) $65,000
D) None of the above

Question 33

If the depreciable investment is $1,000,000 and the MACRS 5-Year class schedule is: Year-1: 20%; Year-2: 32%; Year-3: 19.2%; Year-4: 11.5%; Year-5: 11.5% and Year-6: 5.8% Calculate the depreciation tax shield for Year-2 using a tax rate of 30%:

A) $224,000
B) $60,000
C) $96,000
D) $300,000

Question 34

Proper treatment of inflation in the NPV calculation involves:
I. Discounting nominal cash flows using the nominal discount rate
II. Discounting real cash flows using the real discount rate
III. Discounting nominal cash flows using the real discount rates

A) I only
B) II only
C) III only
D) I and II only

Question 35

If the nominal interest rate is 7. 5% and the inflation rate is 4%, what is the real interest rate?

A) 4%
B) 9.5%
C) 3.4%
D) None of the above

Question 36

For project A in year-2, inventories increase by $12,000 and accounts payable by $2,000. Calculate the increase or decrease in net working capital for year-2.

A) Decreases by $14,000
B) Increases by $14,000
C) Decreases by $10,000
D) Increases by $10,000

Question 37

The NPV value obtained by discounting nominal cash flows using the nominal discount rate is the:
I. same as the NPV value obtained by discounting real cash flows using the real discount rate
II) same as the NPV value obtained by discounting real cash flows using the nominal discount rate
III. same as the NPV value obtained by discounting nominal cash flows using the real discount rate

A) I only
B) II only
C) III only
D) II and III only

Question 38

Capital equipment costing $250,000 today has 50,000 salvage value at the end of 5 years. If the straight line depreciation method is used, what is the book value of the equipment at the end of two years?

A) $200,000
B) $170,000
C) $140,000
D) $50,000

Question 39

Given the following data for Project M:
$\begin{array}{c}\begin{array}{lll}\\\text {Cash flow in real terms:}\\\text {Real discount rate \( =\mathbf{5} \% \)}\\\text {Nominal discount rate \( =10 \% \)}\\\text {Calculate the NPV of the project}\end{array}\begin{array}{lll}C_{0} & C_{1} & C_{2} \\-200 & 150 & 120\\\\\\\\\end{array}\end{array}$

A) $51.70
B) $35.54
C) $45.21
D) None of the above

Question 40

Real cash flow occurring in year-2 is $60,000. If the inflation rate is 5% per year, the real rate of interest is 2%, calculate the cash flow for the year-2.

A) $60,000
B) $55,422
C) $66,150
D) None of the above

Question 41

By undertaking the analysis in real terms, the financial manager avoids having to forecast inflation.

Question 42

You have been asked to evaluate a project with infinite life. Sales and costs are projected to be $1000 and $500 respectively. There is no depreciation and the tax rate is 30%. The real required rate of return is 10%. The inflation rate is 4% and is expected to be 4% forever. Sales and costs will increase at the rate of inflation. If the project costs $3000, what is the NPV?

A) $500.00
B) $1629.62
C) $365.38
D) None of the above

Question 43

When calculating cash flows, it is important to consider them on an incremental basis.

Question 44

When calculating cash flows, it is important to consider all incidental effects.

Question 45

In the MACRS system of depreciation most industrial equipment fall into the ten- and fifteen-year classes.

Question 46

A project requires an investment of $900 today. It has sales of $1,100 per year forever. Costs will be $600 the first year and increase by 20% per year. Ignoring taxes calculate the NPV of the project at 12% discount rate.

A) $65.00
B) $57.51
C) $100.00
D) Cannot be calculated as g > r

Question 47

Two mutually exclusive projects have the following NPVs and project lives.
$$\begin{array} { r r c } \text { Project } & \text { NPV } & \text { Life } \\\text { Project A } & \$ 5,000 & \text { 3 years } \\\text { Project B } & \$ 6,500 & 5 \text { years }\end{array}$$
If the cost of capital is 15%, which project would you accept?

A) A
B) B
C) Both A and B
D) Reject both A and B

Question 48

Two machines, A and B, which perform the same functions, have the following costs and lives.
$$\begin{array} { c r r } \text { Type } & \text { PV Costs } & \text { Life } \\\text { Machine A } & \$ 6000 & 5 \\\text { Machine B } & \$ 8000 & 7\end{array}$$
Which machine would you choose? The two machines are mutually exclusive and the cost of capital is 15%.

A) Machine A as the EAC is $1789.89
B) Machine B as the EAC is $1922.88
C) Don't buy either machine
D) Accept both A and B

Question 49

You are considering the purchase of one of two machines required in your production process. Machine A has a life of two years. Machine A costs $50 initially and then $70 per year in maintenance. Machine B has an initial cost of $90. It requires $40 in maintenance for each year of its 3 year life. Either machine must be replaced at the end of its life. Which is the better machine for the firm? The discount rate is 15% and the tax rate is zero.

A) Machine A as EAC for Machine A is $100.76
B) Machine B as EAC for Machine B is $79.42
C) Machine A as PV of costs for Machine A is $163.80
D) Machine B as PV of costs for Machine B is $181.33

Question 50

Which of the following countries allow firms to keep two separate sets of books, one for the stockholders and one for the tax authorities like the Internal Revenue Service?
I. U.S.A
II) Japan
III) France

A) I only
B) I and II only
C) I, II, and III only
D) None of the above

Question 51

Sunk costs are bygones, they are unaffected by the decision to accept or reject and should be ignored.

Question 52

Opportunity costs should not be included as they are missed opportunities.

Question 53

Do not forget to include interest and dividend payments when calculating the project's cash flows.

Question 54

Working capital is needed additional investment in the project and should considered for cash flow estimation.

Question 55

Depreciation acts as a tax shield in reducing the taxes.

Question 56

OM Construction Company must choose between two types of cranes. Crane A costs $600,000, will last for 5 years, and will require $60,000 in maintenance each year. Crane B costs $750,000 and will last for seven years and will require $30,000 in maintenance each year. Maintenance costs for cranes A and B are incurred at the end of each year. The appropriate discount rate is 12% per year. Which machine should OM Construction purchase?

A) Crane A as EAC is $226,444
B) Crane B as EAC is $194,336
C) Crane A as the PV is $816,286
D) Cannot be calculated as the revenues for the project are not given

Question 57

RainMan Inc. is in the business of producing rain upon request. They must decide between two investment projects; a new airplane for seeding rain clouds or a new weather control machine built by Dr. Nutzbaum. The discount rate for the new airplane is 9%, while the discount rate for the weather machine is 39% (it happens to be higher risk). Which investment should the company select and why?
$$\begin{array} { l c c } \text { Year } & \text { Airplane } & \text { Weather Machine } \\0 & - 900 & - 900 \\1 & 500 & 550 \\2 & 600 & 600 \\3 & & 685\end{array}$$

A) Airplane because is has a higher NPV
B) Weather machine because is has a higher NPV
C) Airplane because is has a higher annuity
D) Weather machine because is has a higher annuity

Question 58

Germany allows firms to choose the following depreciation methods:
I. Straight-line method
II. Declining-balance method

A) I only
B) II only
C) I and II only
D) Germany allows a totally different system

Question 59

Working capital is one of the most common sources of mistakes in estimating project cash flows.

Question 60

A project requires an initial investment of $200,000 and is expected to produce a cash flow before taxes of 120,000 per year for two years. [i.e. cash flows will occur at t = 1 and t = 2]. The corporate tax rate is 30%. The assets will be depreciated using MACRS - 3 year schedule: (t=1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can make use of all applicable tax shields. The opportunity cost of capital is 11%. Assume that the asset can be sold for book value. Calculate the IRR for the project: (approximately)

A) 12.00%
B) 11.00%
C) 17.73%
D) None of the above

Question 61

When evaluating a projects with positive NPV but variable life spans, the proper technique to employ is the equivalent annual annuity (EAA) approach.

Question 62

Equivalent annual cash flow approach can be used to determine the year in which the existing machine can be profitably replaced with a new machine.

Question 63

You should replace a machine when the EAC of continuing to operate it exceeds the EAC of the new machine.

Question 64

How do you compare projects with different lives?

Question 65

Briefly discuss how taxes are taken into consideration in countries like Japan.

Question 66

Briefly explain the difference between an equivalent annual cost and an equivalent annual annuity.

Question 67

All large U.S. corporations keep two separate sets of books, one for the stockholders and one for the Internal Revenue Service.

Question 68

Briefly explain how the cost of excess capacity is taken into consideration.

Question 69

Briefly explain the acronym MACRS.

Question 70

Briefly explain how the decision to replace an existing machine is made?

Question 71

Define the term cash flow for a project.

Question 72

The rule for comparing machines with different lines is to select the machine with the greatest equivalent annual cost (EAC).