Chapter 6.pdf

Chapter 06 - Making Investment Decisions with the Net Present Value Rule

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Chapter 06

Making Investment Decisions with the Net Present Value Rule

Multiple Choice Questions

1. 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

2. 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

3. 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

4. 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


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5. 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

6. 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

7. 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)

8. 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


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9. 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

10. 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

11. 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

12. The principal short-term assets are: I) Cash, II) Accounts receivable, III) Inventories, and IV) Accounts Payable A. I only B. I and IV only C. I, II, and III D. IV only


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13. 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

14. 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

15. 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

16. 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

17. 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


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18. 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

19. 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

20. 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

21. 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%


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22. 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

23. 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

24. Given the following data for Project M:

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




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26. 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%

27. 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

28. 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

29. 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


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30. 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

31. 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

32. 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

33. 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


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34. 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

35. 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

36. 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

37. 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


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38. 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

39. 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

40. 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


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41. 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

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

43. 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

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


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45. Germany allows firms to choose the following depreciation methods: I) Straight-line method, and II) Declining-balance method A. I only B. II only C. I and II only D. Germany allows a totally different system

46. Two machines, A and B, which perform the same functions, have the following costs and lives.

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

47. Two mutually exclusive projects have the following NPVs and project lives.

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


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48. 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

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

50. 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?

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


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51. Using the technique of equivalent annual cash flows and a discount rate of 7%, what is the value of the following project?

A. 3.06 B. 3.61 C. 10.25 D. 12.23

True / False Questions

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

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

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

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

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


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

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

59. Depreciation acts as a tax shield in reducing the taxes. True False

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

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

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

63. 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. True False


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

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

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

67. Equivalent annual cash flows are used whenever the lives of projects are the same. True False

Short Answer Questions

68. Define the term cash flow for a project.


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69. What are some of the important points to remember while estimating the cash flows of a project?

70. Briefly explain how inflation is treated consistently while estimation the project NPV.

71. Briefly explain the acronym MACRS.

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


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73. What are some of the additional factors that have to be considered while estimating cash flows in other countries and currencies?

74. How do you compare projects with different lives?

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

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


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


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Chapter 06 Making Investment Decisions with the Net Present Value Rule Answer Key

Multiple Choice Questions

1. 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

Type: Easy

2. 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

Type: Medium

3. 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

Type: Medium


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4. 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

Type: Easy

5. 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

Type: Medium

6. 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

Type: Difficult


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7. 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)

Type: Medium

8. 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

Type: Medium

9. 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

Type: Medium


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10. 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

Type: Easy

11. 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

Type: Medium

12. The principal short-term assets are: I) Cash, II) Accounts receivable, III) Inventories, and IV) Accounts Payable A. I only B. I and IV only C. I, II, and III D. IV only

Type: Easy


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13. 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

Type: Medium

14. 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

Type: Medium

15. 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

Type: Medium

16. 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

Type: Difficult


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17. 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

Type: Medium

18. 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

Type: Medium

19. 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

Type: Medium


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20. 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

Type: Medium

21. 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%

1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815) Nominal rate = 0.0815 = 8.15%

Type: Easy

22. 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

1 + real rate = (1 + nominal rate) / (1 + inflation rate) = 1.075/1.04 = 1.0337; real rate = 3.4%

Type: Easy


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23. 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

Real cash flow = 10,816/(1.04^2) = 10,000

Type: Medium



NPV = -200 + 150/1.05 + 120/(1.05^2) = 51.70

Type: Difficult


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NPV = -100 + 75/1.1 + 60/(1.1^2) = 17.77

Type: Difficult

26. 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%

1 + nominal rate = 1.03 * 1.04 = 1.0712; nominal rate = 7.12%

Type: Easy


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27. 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

Type: Medium

28. 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

Nominal cash flow = (60,000)(1.05)^2 = 66,150

Type: Medium

29. 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

Type: Medium


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30. 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

500,000 - (500,000 - 300,000) * 0.35 = 430,000

Type: Difficult

31. 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

Annual depreciation = (250,000 - 50,000)/5 = 40,000 Book value at the end of two years = 250,000 - 80,000 = 170,000

Type: Medium

32. 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

Annual depreciation = $400,000/5 = 80,000 Depreciation for 3 years = 240,000 Book value = 400,000 - 240,000 = 160,000

Type: Medium


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33. 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

Working capital: 6000 + 4000 - 3000 = 7,000

Type: Medium

34. 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

Working capital = 12,000 - 2000 = + 10,000

Type: Medium

35. 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

Type: Difficult


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36. 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

Tax shield effect = (600,000)(0.35) = 210,000

Type: Easy

37. 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

Tax shield effect = (100,000)(0.35) = 35,000

Type: Easy

38. 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

Depreciation for Year-2 = (600,000)(0.32) = 192,000

Type: Easy


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39. 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

Depreciation = (1,000,000)(0.32)(0.3) = 96,000

Type: Easy

40. 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

-200,000 + (103,800/1.12) + ((111,000 + 44,000)/(1.12^2)) = $16,244

Type: Difficult


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41. 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

0 = -200,000 + (103,800/(1 + IRR)) + (155,000/((1 + IRR)^2)) = 17.73%

Type: Difficult

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

NPV = [((1000/1.04) - (500/1.04)) (0.7)] / 0.1 - (3000 ) = $365.38

Type: Difficult


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43. 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

NPV = -900 + (1,100 - 600)/1.12 + (1,100 - (600 * 1.2))/(1.12^2) + (1,100 - 600 (1.2^2))/(1.12)^3 + (1,100 - 600 (1.2^3))/(1.12^4) = $57.51. (The project is stopped when costs> revenues)

Type: Difficult

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

Type: Easy

45. Germany allows firms to choose the following depreciation methods: I) Straight-line method, and II) Declining-balance method A. I only B. II only C. I and II only D. Germany allows a totally different system

Type: Easy


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46. Two machines, A and B, which perform the same functions, have the following costs and lives.

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

EAC(A) = 6,000/3.35215 = 1789.89 EAC(B) = 8000/4.1604 = 1922.88

Type: Difficult

47. Two mutually exclusive projects have the following NPVs and project lives.

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

EAC(A) = 5000/2.2832 = 2189.88 (Accept the project with higher EAC) EAC(B) = 6500/3.35216 = 1939.05

Type: Difficult


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48. 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

PV (A) = 600,000 + 60,000 (3.6048) = 816,286 EAC = 816,286/(3.6048) = $226,444 PV(B) = 750,000 + 30, 000 (4.5638) = 886,913 EAC = 886,913/(4.5638) = $194,336.45 (Accept the project with least annual cost)

Type: Difficult

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

Costs: PV(A) = 50 + 70/1.15 + 70/(1.15^2) = 163.80; EAC = 163.80/(1.6257) = 100.76 PV(B) = 90 + 40/1.15 + 40/(1.15^2) + 40/(1.15^3) = 181.33; EAC = 181.33/2.2832 = 79.42 (Accept the project with least annual cost)

Type: Difficult


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50. 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?

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

NPV of the airplane is 63.72 and the EAA of the airplane is 36.22 NPV of the weather machine is 61.29 and the EAA of the machine is 38.08 Since they have different life spans the weather machine has a higher EAA and should be accepted.

Type: Difficult

51. Using the technique of equivalent annual cash flows and a discount rate of 7%, what is the value of the following project?

A. 3.06 B. 3.61 C. 10.25 D. 12.23

NPV of the project is 12.23 and the EAA of the airplane is 3.61

Type: Medium

True / False Questions


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

Type: Easy

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

Type: Easy

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

Type: Medium

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

Type: Medium

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

Type: Easy

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

Type: Medium


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

Type: Medium

59. Depreciation acts as a tax shield in reducing the taxes. TRUE

Type: Medium

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

Type: Medium

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

Type: Difficult

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

Type: Difficult


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63. 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. TRUE

Type: Medium

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

Type: Medium

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

Type: Difficult

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

Type: Difficult

67. Equivalent annual cash flows are used whenever the lives of projects are the same. FALSE

Type: Difficult

Short Answer Questions


6-42

68. Define the term cash flow for a project.

Cash flow for a project is the net income plus depreciation. Cash flows are always estimated on an after-tax basis.

Type: Easy

69. What are some of the important points to remember while estimating the cash flows of a project?

• Estimate after-tax cash flows on an incremental basis.

• Include all incidental effects.

• Include working capital requirements.

• Include opportunity costs.

• Do not include sunk costs.

• Take inflation into consideration in a consistent manner.

Type: Medium

70. Briefly explain how inflation is treated consistently while estimation the project NPV.

There are two ways to treat inflation consistently in the estimation of NPV of a project. If the discount rate is stated in nominal terms, then consistency requires that project cash flows also be estimated in nominal terms. This might involve using different inflation rates for different components of cash flow. If the discount rate is stated in real terms then real cash flows are estimated for the project. The consistency rule is: discount nominal cash flows at a nominal discount rate and discount real cash flows at a real discount rate.

Type: Medium


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71. Briefly explain the acronym MACRS.

MACRS is short for Modified Accelerated Cost Recovery System. This is the result of the Tax Reform Act of 1986. It is based on a combination of double declining method and straight line depreciation methods. In this system, assets are classified into several classes like 3-year class, 5-year class etc. Tax depreciation allowed under each asset class is provided in a Table format. It uses mid-year convention and hence an asset under 3-year class has depreciation for four years, and etc. The alternative is to use the straight-line depreciation method.

Type: Medium

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

In Japan and all of the European Community countries, it is not possible to separate tax accounts reported to the government and those reported to shareholders. They must be same. In some countries it is not possible to use the accelerated depreciation.

Type: Medium

73. What are some of the additional factors that have to be considered while estimating cash flows in other countries and currencies?

• Currency of the cash flow should be relevant to the project

• Use an appropriate inflation rate for the project

• Use the relevant tax rate and depreciation method for the project

• Use the appropriate discount rate for the project

Type: Medium


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74. How do you compare projects with different lives?

Projects with different lives are compared assuming that the projects are repeated to infinity, called replacement chains. The replacement chains are analyzed using equivalent annual costs (EAC) or adjusted NPVs (adjusted for differences in project lives).

Type: Difficult

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

The decision to replace an existing machine is done for economic or technological reasons or for both. For this equivalent annuity approach is used. As long as the benefits exceed equivalent annual costs replacing old machine with a new one, the decision will be a sound one.

Type: Difficult

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

Many managers assume that the marginal cost of excess capacity is zero and encourage employees to use up the excess capacity. This may not be a very sound way to utilize excess capacity. If we use the equivalent annual cost (EAC) approach cost of excess capacity can be estimated easily. Indiscriminate use of excess capacity may result in replacing the existing machine with a new machine sooner. This is the cost of excess capacity and must be taken into consideration.

Type: Difficult


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

The technique of equivalent annual cash flows can be employed for evaluating cost saving projects or projects that generate positive NPVs. When used to evaluate cost savings projects the term equivalent annual cost is used and we seek to minimize this number. When looking at positive NPV projects the term equivalent annual annuity is used and we seek to maximize this number.

Type: Difficult

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