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

Question 1

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

Answer 1

False

Question 2

Sunk costs do not affect project NPV.

Answer 2

True

Question 3

Upon the sale of equipment at the end of its useful life,tax liability will be incurred whenever the book value of the equipment exceeds the sales price.

Answer 3

False

Question 4

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

Question 5

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

Question 6

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

Question 7

A project will always generate extra overhead costs.

Question 8

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows (i.e.,the difference between cash flow with project and cash flow without project).

Question 9

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

Question 10

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

Question 11

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

Question 12

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

Question 13

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

Question 14

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 15

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.

Question 16

Opportunity costs are evaluated for investment decisions at their historical (that is,book)cost.

Question 17

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

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

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.

Question 21

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 22

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 estimated NPV.

Question 23

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 24

Projects that are calculated as having 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 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 26

Which 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) All of these methods will provide similar results.

Question 27

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

Question 28

Assume your firm has an unused machine that originally cost $75,000,has a book value of $20,000,and is currently worth $25,000.Ignoring taxes,the correct opportunity cost for this machine in capital budgeting decisions is:

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

Question 29

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

Question 30

The value of a proposed capital budgeting project depends on the:

A) total cash flows produced.
B) incremental cash flows produced.
C) accounting profits produced.
D) increase in total sales produced.

Question 31

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

A) project actually increased overhead expenses.
B) overhead cannot be recovered at the end of the project.
C) overhead cannot be allocated to other projects.
D) accountant is required to allocate costs to this project.

Question 32

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 2.5% expected annual inflation,how far off in total dollars is your 3-year forecast?

A) $37,813
B) $50,000
C) $52,550
D) $76,250

Question 33

If a project's cash flows exceed the project's incremental cash flows,it is likely that the:

A) project interacts with other aspects of the firm.
B) project must have high depreciation expense.
C) opportunity cost of capital must be high.
D) project will have a negative NPV.

Question 34

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

A) Income tax rates
B) Estimates of 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 35

A cost should be considered sunk when it:

A) is fully depreciated.
B) produces no additional sales revenues.
C) has no effect on future flows.
D) is replaced by costs that are not yet sunk.

Question 36

Which of the following would be more likely 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 37

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

A) Include sunk costs when they are relatively large.
B) Include sunk costs if they improve the project's NPV.
C) Include sunk costs if they are considered to be overhead costs.
D) It is never appropriate to include sunk costs.

Question 38

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 39

If the adoption of a new product will reduce the sales of an existing product,then the:

A) new product should not be undertaken.
B) old product should be abandoned.
C) incremental benefits of the new product may be overestimated.
D) incremental benefits of the new product may be underestimated.

Question 40

Which 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 41

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 42

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 43

Methods of accelerated depreciation:

A) allow more 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 44

A parcel of corporate land was recently dedicated as the new plant site.What cost allocation should the land receive,based on the following: original cost of $200,000,market value of $300,000,net book value of $200,000,a recent offer to purchase for $250,000.

A) $200,000
B) $250,000
C) $275,000
D) $300,000

Question 45

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 (revenues will be unchanged)before you would wait 2 years to invest?

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

Question 46

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 47

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

A) 3.5%
B) 9.7%
C) 14.0%
D) 20.0%

Question 48

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

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

Question 49

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 50

Which of the following costs probably should not be allocated to the investment needed for a new project?

A) Increase in accounts receivable
B) New warehouse, built for this project
C) 25% of the Vice President's salary
D) Labor expense for employees in new warehouse

Question 51

What nominal annual return is required on an investment for an investor to experience a 12% gain in purchasing power? Assume inflation to be 4%.

A) 7.69%
B) 9.29%
C) 12.00%
D) 16.48%

Question 52

New projects or products can have an indirect effect on the firm as well as a direct effect.Which of the following appears to be an indirect effect of launching a new product?

A) Additional working capital is required.
B) Sales force will need to be increased.
C) Sales of a similar product of your firm's will decline.
D) Additional machinery must be purchased.

Question 53

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 54

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 number of years in each recovery class.

Question 55

Which 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 56

Assume that sales revenues are increasing more rapidly than product costs,but that a project's cash flows have been represented as an annuity when calculating NPV.Which of the following problems may occur?

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 57

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

A) inflation must be added to the nominal rate.
B) investment returns do not increase purchasing power.
C) nominal flows should be discounted with real rates.
D) inflation is expected to occur.

Question 58

A project anticipates net cash flows of $10,000 at the end of year 1,with such amount growing at the expected 5% rate of inflation over the subsequent 4 years.Calculate the real present value of this 5-year cash stream if the firm employs a nominal discount rate of 15%.

A) $33,522
B) $38,377
C) $43,294
D) $55,000

Question 59

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 60

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 61

Capital budgeting projects typically assume that all cash flows transpire at the end of the year.The reason for this is that:

A) less tax liability results from this practice.
B) balance sheets are prepared at the end of the year.
C) it is easier for the analyst in this manner.
D) most corporations collect their cash at the end of the year.

Question 62

Which of the following is not accurate in depicting cash flows from operations?

A) (revenues - expenses)(1 - tax rate) + (depreciation * tax rate)
B) (revenues - expenses - taxes paid)
C) (net profit + depreciation)
D) (revenues - cash expenses - taxes paid)

Question 63

The additional inventory investment that is often required for new projects can be partially funded by:

A) switching to accelerated depreciation methods.
B) reducing accounts receivable.
C) decreasing equipment purchases.
D) increasing accounts payable.

Question 64

Why is it fairly easy to fall into the trap of discounting real cash flows with nominal rates?

A) It is difficult to determine real discount rates.
B) Increases in nominal cash flows are often not forecast.
C) Inflation does not impact cash flows, but it does impact discount rates.
D) Increases in revenues are offset by increases in costs.

Question 65

Which of the following statements is incorrect?

A) Real cash flows must be discounted at a real discount rate.
B) (1 + real rate of interest) = (1 + nominal rate of interest )/(1 + inflation rate).
C) Real rate of interest almost equals "nominal rate of interest - inflation rate."
D) None of these.

Question 66

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 required in additional working capital,and a 35% tax rate?

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

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 if sales price exceeds book value.

Question 68

The following are all important items to look out for when you perform capital budgeting for a company except

A) be aware of allocated overhead costs.
B) include all indirect effects.
C) include sunk costs.
D) include opportunity costs.

Question 69

What is the present value at a 10% discount rate of the depreciation tax shield for a firm in the 35% tax bracket that purchases a $50,000 asset being depreciated straight-line over a 5-year life to a zero salvage value?

A) $10,866
B) $13,268
C) $17,500
D) $37,908

Question 70

Opportunity costs for organizational resources:

A) are limited to the explicit cash flows involved.
B) are determined according to the marginal tax rate.
C) can involve no cash flows.
D) should not be determined for existing products.

Question 71

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 72

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 73

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 74

For a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense,the depreciation tax shield would be:

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

Question 75

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 76

Which of the following statements regarding depreciation is incorrect?

A) The depreciation tax shield adjusts with the level of inflation.
B) The nominal amount of depreciation is fixed, thus the higher the rate of inflation, the lower the real value of the depreciation that you can claim.
C) Tax law allows accelerated depreciation.
D) The rate at which firms are permitted to depreciate equipment is known as the modified accelerated cost recovery system, or MACRS.

Question 77

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

A) equal for all depreciation methods.
B) higher with MACRS than straight-line depreciation.
C) higher for the 10^th year than the 7-year recovery period class.
D) likely to increase annually due to inflation.

Question 78

A tax shield is equal to the reduction in:

A) tax liability resulting from a deductible expense.
B) taxable income resulting from a deductible expense.
C) cash flow from an expense.
D) net income.

Question 79

What rate of nominal growth is expected in sales if they are currently $1,000,000 and expected to reach $1,600,000 in 5 years?

A) 3.20%
B) 9.86%
C) 12.00%
D) 26.49%

Question 80

New projects or products can provide positive indirect effects as well as negative effects.Which of the following appears to be a positive indirect effect?

A) The new, efficient machine uses less electricity.
B) Orders of your complementary products increase.
C) The project has a positive NPV.
D) Accelerated methods of depreciation can be used.