Deck 9: Using Discounted Cash-Flow Analysis to Make Investment Decisions

Question 1

As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected.

Answer 1

True

Question 2

The method of financing a project affects the determination of its cash flows for capital budgeting purposes.

Answer 2

False

Question 3

When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them.

Answer 3

True

Question 4

In project analysis, allocations of overhead should be limited to only those that represent additional expense.

Question 5

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows.

Question 6

Opportunity costs are evaluated for investment decisions at their historical cost.

Question 7

The net cash flow from the sale of an asset will exceed the asset's sale price when a firm has positive taxable income and the asset's book value exceeds its market value.

Question 8

Discounting real cash flows with real interest rates provides an overly optimistic idea of a project's value.

Question 9

Suppose you finance a project partly with debt. You should neither subtract the debt proceeds from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows.

Question 10

An asset in the MACRS 5-year class life will have depreciation expense in 6 different years.

Question 11

Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows.

Question 12

Investments in working capital, just like investments in plant and equipment, result in cash inflows at time zero.

Question 13

A project will always generate extra overhead costs.

Question 14

Discounting real cash flows at a nominal rate is a serious mistake.

Question 15

When additional funds must be committed to working capital, those funds are assumed to be recovered at the end of the project's life.

Question 16

Capital budgeting analysis focuses on cash flow as opposed to profits.

Question 17

Sunk costs do not affect the net present value of a project.

Question 18

The present value of the total depreciation tax shield will be higher when an asset uses MACRS than when depreciated straight-line.

Question 19

If a project permits a reduction in the level of working capital, this reduction is assumed to increase cash flows.

Question 20

Sunk costs remain the same whether or not you accept the project.

Question 21

You are evaluating a new project that will introduce a revolutionary new product that will be produced by a new, highly efficient machine. Which one of these will lower the net present value of that project?

A) A reduction in the firm's total variable costs due to the purchase of the new machine
B) A loss of current sales due to the introduction of the new product
C) The increase in annual depreciation resulting from the asset purchase
D)The sale of the machine after it is fully depreciated

Question 22

Which one of the following is a situation where a new project will require a cash investment in net working capital?

A) Inventory levels will be reduced when the project is introduced.
B) All sales related to the project will be cash sales to a subsidiary.
C) The project will increase inventory more than accounts payable.
D)The project will require additional inventory which will be financed by a supplier.

Question 23

Cash flow from operations = (revenues - cash expenses) × (1 - tax rate) + (depreciation × tax rate).

Question 24

Projects that have negative NPVs should be:

A) depreciated over a longer time period.
B) charged less in overhead costs.
C) discounted using lower rates.
D)rejected or abandoned.

Question 25

The rationale for not including sunk costs in capital budgeting decisions is that they:

A) are usually small in magnitude.
B) revert at the end of the investment.
C) have no incremental effect.
D)reduce the project's net present value.

Question 26

Which one of these represents a cash outflow for a project?

A) A sunk cost
B) Increase in accounts receivable
C) Depreciation
D)Accrued expenses

Question 27

Corporate income statements are designed primarily to show:

A) cash flows during a period.
B) account balances at the end of a period.
C) performance during a period.
D)market values of assets and liabilities.

Question 28

A profitable firm is considering a 7-year project that requires $135,000 of new equipment which will be depreciated as MACRS 5-year property, after which time it will be worthless. When will this equipment affect the project's cash flows?

A) Every year for 5 years
B) At the time of purchase only
C) Every year for 6 years
D)Every year for 7 years

Question 29

Which one of the following changes in working capital is least likely, given an increase in the overall level of sales?

A) An increase in inventories
B) An increase in accounts payable
C) A decrease in accounts receivable
D)An increase in notes payable

Question 30

The opportunity cost of an asset:

A) should be depreciated annually.
B) can differ depending on market conditions.
C) is typically ignored in capital budgeting.
D)is important only for parcels of land.

Question 31

A project is expected to increase inventory by $17,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000. What is the project's cash flow from net working capital at time zero?

A) -$8,000
B) $8,000
C) -$6,000
D)$6,000

Question 32

The total depreciation tax shield equals the product of depreciation and the tax rate.

Question 33

Assume your firm has an unused machine that originally cost $75,000, has a book value of $20,000, and a market value of $25,000. Ignoring taxes, what is the opportunity cost of this machine?

A) $75,000
B) $25,000
C) $20,000
D)$5,000

Question 34

Net working capital is expected to increase by $25,000 over the 5-year life of a project. What is the effect of net working capital on the project's net present value if the cost of capital is 15%?

A) NPV will not be affected because the $25,000 will all be recouped.
B) NPV will increase by $12,429.42.
C) NPV will decrease by $25,000.
D)NPV will decrease by $12,570.58.

Question 35

A project will reduce the amount of inventory that a firm must carry. What effect will this have on the project's cash flows if all inventory is purchased for cash?

A) There will only be a cash outflow at time zero.
B) There will be no effect on the cash flows since the inventory has already been paid for.
C) There will be a cash outflow at time zero and an equal cash inflow when the project ends.
D)There is an assumed cash outflow equal to the inventory reduction at the end of the project.

Question 36

If the adoption of a new product will reduce the sales of an existing product, then the projected sales on the pro forma statement should:

A) reflect only the sales of the new product.
B) include only the reduction amount.
C) equal the incremental increase in total sales.
D)be adjusted upward by the reduction amount.

Question 37

Which one of the following is least likely to influence the opportunity cost of an asset?

A) Its current market value
B) Alternative uses for the asset
C) The current demand for the asset
D)Its current book value

Question 38

What is the effect on a firm's net working capital if a new project requires a $30,000 increase in inventory, a $10,000 increase in accounts receivable, a $35,000 increase in machinery, and a $20,000 increase in accounts payable?

A) -$5,000
B) $10,000
C) $20,000
D)$55,000

Question 39

A proposed project requires an initial investment of $8,500 in current assets, 75% of which will be financed with accounts payable. The project will have:

A) an initial cash outflow of $8,500 at time zero for net working capital.
B) a cash outflow for net working capital at the end of the project.
C) a cash inflow at the end of the project from net working capital.
D)a cash outflow for net working capital every year of the project's life.

Question 40

When is it appropriate to include sunk costs in the evaluation of a project?

A) Whenever they are relatively large
B) If they improve the project's NPV
C) If they are considered to be overhead costs
D)Never

Question 41

The recovery of an additional investment in working capital is assumed to:

A) occur at the end of a project's life.
B) occur at the beginning of a project's life.
C) occur whenever the project first shows a profit.
D)be a sunk cost.

Question 42

What is the annual depreciation tax shield for a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense?

A) $10,500
B) $30,000
C) $35,000
D)$65,000

Question 43

A tax shield is equal to the reduction in a firm's:

A) total tax liability resulting from a tax deductible expense.
B) taxable income resulting from depreciation.
C) taxable income resulting from a decrease in long-term debt.
D)net income caused by depreciation.

Question 44

Which one of the following categories would be least likely to require annual adjustments in a capital budgeting analysis due to the effects of inflation?

A) Sales
B) Expenses
C) Working capital
D)Depreciation expense

Question 45

Given a positive discount rate, which one of the following changes would increase the NPV of a project?

A) Increasing the firm's opportunity cost of capital
B) Realizing a net decrease in working capital
C) Spreading the total cash inflows over a longer time interval
D)Increasing the project's estimated expenses

Question 46

Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to incorporate the 3% expected annual inflation, how far off in total dollar sales is your 3-year forecast?

A) $45,450
B) $60,900
C) $52,550
D)$76,250

Question 47

Which one of the following would not be expected to affect the decision of whether to undertake an investment?

A) Income tax rates
B) Estimates of future inflation rates
C) Sales reductions in other products caused by this investment
D)Cost of the feasibility study that was conducted for this project

Question 48

The likely effect of discounting nominal cash flows with real interest rates will be to:

A) make an investment's NPV appear more attractive.
B) make an investment's NPV appear less attractive.
C) correctly calculate an investment's NPV if inflation is expected.
D)correctly calculate an investment's NPV, regardless of expected inflation.

Question 49

The correct method to handle overhead costs in capital budgeting is to:

A) allocate a portion to each project.
B) allocate them to projects with the highest NPVs.
C) ignore all except identifiable incremental amounts.
D)ignore them in all cases.

Question 50

Which one of the following would be more apt to make an unacceptable project appear acceptable?

A) Discounting real cash flows with real rates
B) Discounting nominal cash flows with real rates
C) Discounting real cash flows with nominal rates
D)Discounting nominal cash flows with nominal rates

Question 51

What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense, and a 35% marginal tax rate?

A) $26,250
B) $43,750
C) $70,000
D)$75,000

Question 52

Capital budgeting proposals should be evaluated as if the project were financed:

A) entirely by debt.
B) entirely by equity.
C) half by debt and half by equity.
D)with the highest cost source of funds, to be safe.

Question 53

Changes in net working capital can occur at:

A) the beginning of a project.
B) the end of a project.
C) any time during the life of a project.
D)the beginning of any accounting period.

Question 54

In what manner does depreciation expense affect investment projects?

A) It reduces cash flows by the amount of the depreciation expense.
B) It increases cash flows by the amount of the depreciation expense.
C) It reduces taxable income by the amount of the depreciation expense.
D)It reduces taxes by the amount of the depreciation expense.

Question 55

Which one of the following methods will provide a correct analysis for capital budgeting purposes?

A) Discounting real cash flows with real rates.
B) Discounting real cash flows with nominal rates.
C) Discounting nominal cash flows with real rates.
D)Discounting nominal cash flows with either real or nominal rates.

Question 56

Allocations of overhead should not affect a project's incremental cash flows unless the:

A) project actually changes the total amount of overhead expenses.
B) overhead will not be recovered at the end of the project.
C) overhead is not currently fully allocated to existing projects.
D)accountant is required to allocate costs to this project.

Question 57

What effect is expected at the end of the life of a project that initially required a $20,000 increase in net working capital?

A) The $20,000 must now be paid by the firm.
B) The firm receives a $20,000 cash inflow.
C) Taxable income is reduced by $20,000.
D)No effects are expected because the $20,000 is now a sunk cost.

Question 58

For an all-equity firm, adding depreciation expense to net profit equals:

A) profit before tax.
B) total revenues.
C) the depreciation tax shield.
D)cash flows from operations.

Question 59

The NPV of an investment proposal becomes negative as a result of allocating a portion of the corporation president's salary. It is most likely the case that:

A) the project should be accepted.
B) rejecting the project is the correct decision.
C) the allocation should be postponed until the project is accepted.
D)the salary should be considered an opportunity cost of the project.

Question 60

What is the amount of the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

A) $260,000
B) $325,000
C) $360,000
D)$425,000

Question 61

The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to:

A) switch to an accelerated method of depreciation.
B) be reacquainted with the concept of sunk costs.
C) reduce net working capital assigned to the project.
D)reduce discount rates to improve NPV.

Question 62

At current prices and a 13% cost of capital, a project's NPV is $100,000. By what minimum amount must the initial cost of the project decrease before you would wait 2 years to invest? Assume all else is held constant.

A) $21,685
B) $26,000
C) $27,690
D)$29,380

Question 63

Which one of the following statements regarding depreciation is correct?

A) The depreciation tax shield adjusts annually with the level of inflation.
B) The real amount of annual depreciation is fixed, thus the higher the rate of inflation, the higher the depreciation tax shield.
C) Tax law allows accelerated depreciation to be used for tax purposes.
D)MACRS can be used for accounting purposes but not for tax purposes.

Question 64

What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, $2,000 initial requirement for additional working capital, and a 35% tax rate?

A) $8,450
B) $12,600
C) $12,650
D)$14,000

Question 65

A new project requires an increase in both current assets and current liabilities of $125,000 each. What is the overall impact on the net working capital investment?

A) An increase of zero
B) An increase of $125,000
C) An increase of $250,000
D)An increase of $62,500, when averaged over the life of the project

Question 66

The primary difficulty in the allocation of overhead costs to prospective projects is that the:

A) allocation will reduce the project's NPV.
B) discount rate is unknown.
C) costs may not represent an incremental expense.
D)expenses may have been previously allocated.

Question 67

When a depreciable asset is ultimately sold, the sales price is:

A) fully taxable.
B) nontaxable.
C) nontaxable only if accelerated depreciation was used.
D)taxable to the extent that the sales price exceeds book value.

Question 68

An investment today of $25,000 promises to return $10,000 annually for the next 3 years. What is the real rate of return on this investment if inflation averages 6% annually during the period?

A) 3.49%
B) 9.78%
C) 4.84%
D)6.38%

Question 69

Assume that a project's sales revenues are expected to increase more rapidly than product costs, but the project's cash flows have been represented as a fixed annuity when calculating NPV. Which one of the following problems might exist within this analysis?

A) Nominal cash flows are possibly being discounted with a real rate.
B) Real cash flows are possibly being discounted with a nominal rate.
C) Nominal cash flows are possibly being discounted with a nominal rate.
D)Real cash flows are possibly being discounted with a real rate.

Question 70

A firm plans to purchase a $50,000 asset that will be depreciated straight-line over a 5-year life to a zero salvage value. What is the present value of the resulting depreciation tax shield if the tax rate is 35% and the discount rate is 10%?

A) $10,866.67
B) $13,267.75
C) $17,500.00
D)$37,908.18

Question 71

Which one of the following statements is most likely to be correct for a project in which the NPV is negative when the cash inflows are based on net income?

A) NPV may turn positive after adjusting for depreciation expense.
B) NPV should be calculated with pretax cash flows rather than net income.
C) NPV has probably been overestimated.
D)The project should be rejected or abandoned.

Question 72

The opportunity cost of a resource should be considered in project analysis, unless:

A) negative cash flows result from its use.
B) the resource was purchased in a prior time period.
C) the resource has been fully depreciated.
D)the resource has no identifiable market value.

Question 73

Methods of accelerated depreciation:

A) allow more total depreciation over the asset's life.
B) decrease the depreciation tax shield.
C) increase the depreciation tax shield.
D)allow assets to be depreciated more rapidly.

Question 74

A new, more efficient machine will last 4 years and allow inventory levels to decrease by $100,000 over its life. At a cost of capital of 13%, how does the net working capital change affect the project's NPV?

A) NPV increases by $38,668.13.
B) NPV increases by $61,330.09.
C) NPV will not change.
D)NPV increases by $100,000.

Question 75

Why is accelerated depreciation often favored for the corporation's set of tax books?

A) It increases the total depreciation tax shield over the project's life.
B) It reduces the total amount of taxes paid over the project's life.
C) It increases net accounting profits over the project's life.
D)It impacts favorably with the time value of money.

Question 76

A project anticipates net cash inflows of $10,000 at the end of year 1, with that amount increasing at the expected 4% rate of inflation over the subsequent 4 years. The initial project cost is $12,800. Calculate the real present value of this 5-year cash stream if the firm employs a nominal discount rate of 10.76%.

A) $33,522.30
B) $28,756.79
C) $33,294.07
D)$26,311.15

Question 77

The present value of the depreciation tax shield at any given discount rate is:

A) equal for all depreciation methods.
B) higher with MACRS than with straight-line depreciation.
C) higher for the 7-year recovery period than for the 5-year recovery period class.
D)likely to increase annually due to inflation.

Question 78

When the real rate of interest is less than the nominal rate of interest, then:

A) disinflation must be occurring.
B) investment returns cannot increase the purchasing power of an investment.
C) nominal cash flows should be discounted with real rates.
D)the rate of inflation must be positive.

Question 79

Under the MACRS:

A) all assets are depreciated over 5 years.
B) depreciable percentages decline throughout the asset's class life.
C) straight-line depreciation percentages are doubled.
D)assets are assumed to be purchased and sold midyear.

Question 80

The modified accelerated cost recovery system (MACRS) allows an increase:

A) in total depreciation over the asset's life.
B) in annual depreciation during earlier years.
C) in real but not nominal depreciation expense.
D)in the asset's depreciable cost basis.