Deck 8: Fundamentals of Capital Budgeting

Question 1

Which of the following statements is FALSE?

A)Project externalities are direct effects of the project that may increase or decrease the profits of other business activities of the firm.
B)Incremental earnings are the amount by which the firm's earnings are expected to change as a result of the investment decision.
C)The average selling price of a product and its cost of production will generally change over time.
D)Any money that has already been spent is a sunk cost and therefore irrelevant in the capital budgeting process.

Answer 1

Project externalities are direct effects of the project that may increase or decrease the profits of other business activities of the firm.

Question 2

Which of the following statements is FALSE?

A)Many projects use a resource that the company already owns.
B)When evaluating a capital budgeting decision,we generally include interest expense.
C)Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project.
D)As a practical matter,to derive the forecasted cash flows of a project,financial managers often begin by forecasting earnings.

Answer 2

When evaluating a capital budgeting decision,we generally include interest expense.

Question 3

The amount that Ford Motor Company will owe in taxes next year without the launch of the new SUV is closest to:

A)$24.0 million
B)$56.0 million
C)$31.5 million
D)$13.5 million

Answer 3

$24.0 million

Question 4

The level of incremental sales associated with introducing the new one hour photo service is closest to:

A)$90,000
B)$150,000
C)$60,000
D)$120,000

Question 5

Which of the following statements is FALSE?

A)When evaluating a capital budgeting decision,the correct tax rate to use is the firm's average corporate tax rate.
B)To determine the capital budget,firms analyze alternative projects and decide which ones to accept through a process called capital budgeting.
C)A new product typically has lower sales initially,as customers gradually become aware of the product.
D)Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project.

Question 6

Suppose that if GSI drops the price on the Glucoscan 3000 immediately,it can increase sales over the next year by 30% to 130,000 units.The incremental impact of this price drop on the firms EBIT is closest to:

A)a decline of 1.5 million.
B)an increase of 1.5 million.
C)a decline of 2.4 million.
D)an increase of 2.4 million.

Question 7

The amount that Ford Motor Company will owe in taxes next year with the launch of the new SUV is closest to:

A)$13.5 million
B)$31.5 million
C)$56.0 million
D)$24.0 million

Question 8

Money that has been or will be paid regardless of the decision whether or not to proceed with the project is:

A)cannibalization.
B)considered as part of the initial investment in the project.
C)an opportunity cost.
D)a sunk cost.

Question 9

Which of the following statements is FALSE?

A)The ultimate goal in capital budgeting is to determine the effect of the decision to take a particular project on the firm's cash flows.
B)To the extent that overhead costs are fixed and will be incurred in any case,they are incremental to the project and should be included in the capital budgeting analysis.
C)Unlevered Net Income = (Revenue - Costs - Depreciation)× (1 - τ_c).
D)Earnings are not cash flows.

Question 10

Which of the following statements is FALSE?

A)Sales will ultimately decline as the product nears obsolescence or faces increased competition.
B)Managers sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it,the prior investment will wasted.
C)With straight-line depreciation the asset's cost is divided equally over its life.
D)A projects unlevered net income is equal to its incremental revenues less costs and depreciation,evaluated on an pre-tax basis.

Question 11

Suppose that of the 60% of FFL's current overnight photo customers,half would start taking their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour service.The level of incremental sales in this case is closest to:

A)$60,000
B)$150,000
C)$90,000
D)$120,000

Question 12

A decrease in the sales of a current project because of the launching of a new project is:

A)cannibalization.
B)a sunk cost.
C)an overhead expense.
D)irrelevant to the investment decision.

Question 13

Which of the following statements is FALSE?

A)The simplest method used to calculate depreciation is the straight-line method.
B)A sunk cost is any unrecoverable cost for which the firm is already liable.
C)Unlevered Net Income = EBIT × τ_c.
D)The decision to continue or abandon should be based only on the incremental costs and benefits of the project going forward.

Question 14

The value of currently unused warehouse space that will be used as part of a new capital budgeting project is:

A)an opportunity cost.
B)irrelevant to the investment decision.
C)an overhead expense.
D)a sunk cost.

Question 15

Which of the following statements is FALSE?

A)We begin the capital budgeting process by determining the incremental earnings of a project.
B)The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax income.
C)Investments in plant,property,and equipment are directly listed as expense when calculating earnings.
D)The opportunity cost of using a resource is the value it could have provided in its best alternative use.

Question 16

Which of the following statements is FALSE?

A)Because value is lost when a resource is used by another project,we should include the opportunity cost as an incremental cost of the project.
B)Sunk costs are incremental with respect to the current decision regarding the project and should be included in its analysis.
C)Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation.
D)When computing the incremental earnings of an investment decision,we should include all changes between the firm's earnings with the project versus without the project.

Question 17

Which of the following statements is FALSE?

A)The firm deducts a fraction of the investments in plant,property,and equipment each year as depreciation.
B)If securities are fairly priced,the net present value of a fixed set of cash flows is independent of how those cash flows are financed.
C)Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in capital budgeting analysis.
D)A good rule to remember is that if our decision does not affect a cash flow then the cash flow should not affect our decision.

Question 18

Suppose that if GSI drops the price on the Glucoscan 3000 immediately,it can increase sales over the next year by 30% to 130,000 units.Also suppose that for each Glucoscan monitor sold,GSI expects additional sales of $100 per year on glucose testing strips and these strips have a gross profit margin of 75%.Considering the increase in the sale of testing strips,the incremental impact of this price drop on the firms EBIT is closest to:

A)a decline of 1.5 million.
B)a decline of 0.7 million.
C)an increase of 0.7 million.
D)an increase of 1.5 million.

Question 19

Which of the following costs would you consider when making a capital budgeting decision?

A)Sunk cost
B)Opportunity cost
C)Interest expense
D)Fixed overhead cost

Question 20

Which of the following statements is FALSE?

A)A capital budget lists the projects and investments that a company plans to undertake during the coming year.
B)Income Tax = EBIT × (1 - τ_c).
C)When sales of a new product displace sales of an existing product,the situation is often referred to as cannibalization.
D)Overhead expenses are often allocated to the different business activities for accounting purposes.

Question 21

The Sisyphean Company is considering a new project that will have an annual depreciation expense of $2.5 million.If Sisyphean's marginal corporate tax rate is 40% and their average corporate tax rate is 30%,then what is the value of the depreciation tax shield on their new project?

A)$750,000
B)$1,000,000
C)$1,500,000
D)$1,750,000

Question 22

The amount of incremental income taxes that the Sisyphean Company will pay in the first year on this new project is closest to:

A)$6300
B)$5200
C)$3500
D)$2800

Question 23

What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not?

Question 24

What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not?

Question 25

Which of the following statements is FALSE?

A)Depreciation is not a cash expense paid by the firm.
B)Net Working Capital = Cash + Inventory + Payables - Receivables.
C)Since 1997,companies can "carry back" losses for two years and "carry forward" losses for 20 years.
D)Earnings do not represent real profits.

Question 26

The incremental EBIT in the first year for the Sisyphean Corporation's project is closest to:

A)$18,000
B)$8000
C)$11,700
D)$5200

Question 27

Construct a simple income statement showing the incremental EBIT and the incremental unlevered net income for all three years of the Sisyphean Companies project.

Question 28

Which of the following statements is FALSE?

A)Depreciation expenses have a positive impact on free cash flow.
B)Free Cash Flow = (Revenues - Costs - Depreciation)× (1 - τ_c)- Capital Expenditures - ΔNWC + τ_c × Depreciation.
C)The firm cannot use its earnings to buy goods,pay employees,fund new investments,or pay dividends to shareholders.
D)The depreciation tax shield is the tax savings that results from the ability to deduct depreciation.

Question 29

The depreciation tax shield for the Sisyphean Corporation's project in the first year is closest to:

A)$8000
B)$3500
C)$2800
D)$5200

Question 30

Which of the following questions is FALSE?

A)Net Working Capital = Current Assets - Current Liabilities.
B)Because depreciation is not a cash flow,we do not include it in the cash flow forecast.
C)Tax loss carry backs allow corporations to take losses during the current year and use them to offset income in future years.
D)Earnings are an accounting measure of firm performance.

Question 31

Which of the following cash flows are relevant incremental cash flows for a project that you are currently considering investing in?

A)The tax savings brought about by the project's depreciation expense
B)The cost of a marketing survey you conducted to determine demand for the proposed project
C)Interest payments on debt used to finance the project
D)Research and Development expenditures you have made

Question 32

Which of the following statements is FALSE?

A)The terminal or continuation value of the project represents the market value (as of the last forecast period)of the free cash flow from the project at all future dates.
B)The incremental effect of a project on the firm's available cash is the project's free cash flow.
C)(1 - τ_c)× Depreciation is called the depreciation tax shield.
D)To evaluate a capital budgeting decision,we must determine its consequences for the firm's available cash.

Question 33

You are considering adding a microbrewery on to one of your firm's existing restaurants.This will entail an increase in inventory of $8000,an increase in Accounts payable of $2500,and an increase in property,plant,and equipment of $40,000.All other accounts will remain unchanged.The change in net working capital resulting from the addition of the microbrewery is:

A)$45,500
B)$10,500
C)$6500
D)$5500

Question 34

Your firm is considering building a new office complex.Your firm already owns land suitable for the new complex.The current book value of the land is $100,000,however a commercial real estate agent has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it.When calculating the NPV of your new office complex,ignoring taxes,the appropriate incremental cash flow for the use of this land is:

A)$650,000
B)$0
C)$100,000
D)$750,000

Question 35

Which of the following statements is FALSE?

A)Most projects will require the firm to invest in net working capital.
B)The main components of net working capital are cash,inventory,receivables,and property,plant and equipment.
C)ΔNWC_t = NWC_t - NWC_{t - 1.}
D)In the final year of a project,the firm ultimately recovers the investment in net working capital.

Question 36

You are considering adding a microbrewery on to one of your firm's existing restaurants.This will entail an investment of $40,000 in new equipment.This equipment will be depreciated straight line over five years.If your firm's marginal corporate tax rate is 35%,then what is the value of the microbrewery's depreciation tax shield in the first year of operation?

A)$2800
B)$14,000
C)$5200
D)$26,000

Question 37

Which of the following statements is FALSE?

A)Because only the tax consequences of depreciation are relevant for free cash flow,we should use the depreciation expense that the firm will use for tax purposes in our free cash flow forecasts.
B)A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into based on its overall level of pre-tax income.
C)Free Cash Flow = (Revenues - Costs)× (1 - τ_c)- Capital Expenditures - ΔNWC + τ_c × Depreciation.
D)Net working capital is the difference between current liabilities and current assets.

Question 38

The required net working capital in the first year for the Sisyphean Corporation's project is closest to:

A)$3600
B)$3960
C)$2880
D)$5400

Question 39

Which of the following statements is FALSE?

A)Depreciation is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life.
B)Sometimes the firm explicitly forecast free cash flow over a shorter horizon than the full horizon of the project or investment.
C)Earnings include the cost of capital investments,but do not include non-cash charges,such as depreciation.
D)Firms often report a different depreciation expense for accounting and for tax purposes.

Question 40

The incremental unlevered net income in the first year for the Sisyphean Corporation's project is closest to:

A)$8000
B)$18,000
C)$5200
D)$11,700

Question 41

The change in Net working capital from year one to year two is closest to:

A)A decrease of $360
B)An increase of $360
C)An increase of $396
D)A decrease of $396

Question 42

The free cash flow for the last year of Epiphany's project is closest to:

A)$53,000
B)$38,000
C)$35,000
D)$43,000

Question 43

Ignoring the original investment of $5 million,what is THSI's free cash flow for the first and only year of operation?

A)$5.0 million
B)$3.75 million
C)$8.0 million
D)$6.25 million

Question 44

The incremental unlevered net income of the Shepard Industries project in year one is closest to:

A)$510
B)$415
C)$600
D)$355

Question 45

Assume that Kinston's new machine will be depreciated straight line to a salvage value of $5000 at the end of year three.What is the after-tax salvage value of this project?

Question 46

The depreciation tax shield for the Shepard Industries project in year two is closest to:

A)$84
B)$196
C)$72
D)$96

Question 47

The incremental EBIT for the Shepard Industries project in year two is closest to:

A)$415
B)$875
C)$595
D)$510

Question 48

Assume that THSI's cost of capital for this project is 15%.The NPV of this temporary housing project is closest to:

A)$435,000
B)-$650,000
C)$1,960,000
D)-$435,000

Question 49

You are considering investing $600,000 in a new automated inventory system that will provide after-tax cost savings of $50,000 next year.These cost savings are expected to grow at the same rate as sales.If sales are expected to grow at 5% per year and your cost of capital is 10%,then what is the NPV of the automated inventory system?

A)$400,000
B)$500,000
C)-$100,000
D)$1,000,000

Question 50

The incremental unlevered net income of the Shepard Industries project in year two is closest to:

A)$355
B)$415
C)$600
D)$510

Question 51

The NPV for Epiphany's Project is closest to:

A)$4825
B)$39,000
C)$11,946
D)$20,400

Question 52

Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the past four years.If Luther earns $15 million per year in pre-tax income from now on,Luther first pays taxes in:

A)7 years
B)2 years
C)4 years
D)5 years

Question 53

Calculate the total Free Cash Flows for each of the three years for the Sisyphean Corporation's new project.

Question 54

The required net working capital in the second year for the Sisyphean Corporation's project is closest to:

A)$3960
B)$4360
C)$3190
D)$5940

Question 55

The free cash flow from the Shepard Industries project in year one is closest to:

A)$240
B)$300
C)-$5
D)$390

Question 56

The depreciation tax shield for the Shepard Industries project in year one is closest to:

A)$84
B)$168
C)$96
D)$72

Question 57

The incremental EBIT for the Shepard Industries project in year one is closest to:

A)$360
B)$750
C)$595
D)$510

Question 58

The free cash flow from the Shepard Industries project in year two is closest to:

A)$345
B)$455
C)$275
D)-$5

Question 59

Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year.The firm had depreciation expenses of $125 million and capital expenditures of $150 million.Although they had no interest expense,the firm did have an increase in net working capital of $20 million.What is Bubba Ho-Tep's free cash flow?

A)$170 million
B)$255 million
C)$150 million
D)$5 million

Question 60

The free cash flow for the first year of Epiphany's project is closest to:

A)$43,000
B)$25,000
C)$38,000
D)$45,000

Question 61

Assume that Casa Grande Farms is planning to sell the tractors after two years,when its book value is $119,988,for a total price of $180,000.What is the effect on free cash flow in the year it is sold?

A)A cash inflow of $60,012
B)A cash outflow of $60,012
C)A cash inflow of $39,008
D)A cash outflow of $39,008

Question 62

What decision should Galt Motors take regarding manufacturing the armatures in house?

A)Proceed with in house manufacture since NPV is negative
B)Proceed with in house manufacture since NPV is positive
C)Reject in-house manufacture since NPV is negative
D)Reject in-house manufacture since IRR is greater than 14%

Question 63

The NPV of manufacturing the armatures in house is closest to:

A)1,095,000
B)1,215,000
C)1,225,000
D)1,250,000

Question 64

The incremental cash flow that Galt Motors will incur in year 10 if they elect to manufacture armatures in house is closest to:

A)40,000
B)335,000
C)375,000
D)415,000

Question 65

The incremental cash flow that Galt Motors will incur today (Year 0)if they elect to manufacture armatures in house is closest to:

A)-740,000
B)-700,000
C)-660,000
D)740,000

Question 66

The incremental cash flow that the Krusty Krab will incur today (Year 0)if they elect to upgrade to the new grill is closest to:

A)-80,000
B)-50,000
C)-46,500
D)+30,000

Question 67

Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation method for three-year property starting immediately,then the annual depreciation tax shield in year 2 is closest to:

A)20,785
B)27,991
C)84,000
D)180,000

Question 68

The incremental cash flow that Galt Motors will incur in year 4 if they elect to manufacture armatures in house is closest to:

A)25,000
B)350,000
C)375,000
D)1,250,000

Question 69

The IRR of manufacturing the armatures in house is closest to:

A)48%
B)49%
C)50%
D)53%

Question 70

If the Krusty Krab's opportunity cost of capital is 12%,then the NPV for upgrading to the new grill is closest to:

A)-22,875
B)-15,025
C)7130
D)10,630

Question 71

Assuming that Casa Grande Farms depreciates these tractors straight line over the three year life,then the NPV of buying the tractors is closest to:

A)20,785
B)36,225
C)81,715
D)513,235

Question 72

Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation method for three-year property starting immediately,then the NPV of buying the tractors is closest to:

A)20,785
B)36,225
C)81,715
D)513,235
E)560,785

Question 73

Assume that Kinston's new machine will be depreciated using MACRS according to the following schedule:

What is the NPV of this project?

Question 74

If the Krusty Krab's opportunity cost of capital is 12%,what decision should the Krusty Krab take regarding the new grill?

A)Do not install the new grill since NPV is approximately = - $10,630
B)Install the new grill since NPV is approximately = + $10,630
C)Install the new grill since IRR is approximately = 15%
D)Don't install the new grill since IRR is less than 12%

Question 75

Assume that Kinston's new machine will be depreciated straight line to a salvage value of $5,000 at the end of year three.What is the NPV for this project?

Question 76

Assuming that Casa Grande Farms depreciates these tractors straight line over the three year life,then the annual depreciation tax shield in year 2 is closest to:

A)63,000
B)80,000
C)84,000
D)117,000

Question 77

The incremental after tax cash flow that the Krusty Krab will receive from selling the existing grill is closest to:

A)19,500
B)30,000
C)33,500
D)50,000

Question 78

The incremental cash flow that the Krusty Krab will incur in year 1 if they elect to upgrade to the new grill is closest to:

A)6500
B)7800
C)10,800
D)11,500

Question 79

If the Krusty Krab's opportunity cost of capital is 12%,then the IRR for upgrading to the new grill is closest to:

A)3.25%
B)16.00%
C)18.25%
D)21.00%

Question 80

The continuation value for the trucking division in year five is closest to:

A)1,000,000
B)1,250,000
C)1,275,000
D)1,375,000